A Walk Through the JOBS Act of 2012: Deregulation in the Wake of Financial Crisis

In 2011, on the heels of the financial crisis and after passing
the behemoth known as the Dodd-Frank Act, Congress did something
unexpected: it passed, with wide bipartisan support, a piece of
legislation that rolls back regulation of the financial sector. In
early 2012 President Obama signed it into law. The legislation, the
Jumpstart Our Business Start-ups Act, or JOBS Act of 2012, aims to
help small businesses access capital by lowering barriers in
several areas of the securities laws.

Traditionally, small businesses have relied on personal savings,
help from family and friends, and small banks for cash infusions.
However, the community banks that have typically provided the bulk
of small business loans have been disappearing. Moreover, the fact
that the recent crisis originated in the housing market put
additional pressure on small business lending since many small
businesses use the owner’s home to secure the loan.

While larger businesses have always turned to the capital
markets to raise funds, these markets are more difficult for
smaller companies to access. Regulation has always been a high
barrier to entry, and, until recently, smaller companies have had
no means of reaching a large audience of potential investors as
publicly owned companies do. The advent of the Internet has,
however, removed this second obstacle, and vehicles such as
crowdfunding seem tailor-made to meet small businesses’ funding
needs. The remaining great barrier was therefore regulation. The
JOBS Act takes aim at key regulatory hurdles in several sections of
the securities laws, seeking to lower the thresholds to make
securities offerings a feasible option for a range of small
business models.

Although the JOBS Act has taken important strides toward
beneficial deregulation, more work remains to be done. The act’s
crowdfunding provision is laden with protections that are likely to
make it unworkable. Moreover, the regulations implementing the
provision have rendered it even more cumbersome. Other titles
suffer from similarly poor implementation. Even though some aspects
of the act and its regulations could be improved, the mere
existence of deregulatory legislation aimed at small business and
financial innovation is encouraging and can serve as a template for
other deregulatory attempts going forward.

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Small businesses have been called the backbone of our
economy,1 the nation’s
job-creation engine,2 and the
ultimate expression of American individualism and entrepreneurial
spirit.3 They comprise a wide
array of business models, providing a myriad of goods and services,
making them fertile ground for innovation. Indeed, small businesses
are vital to our country’s growth and prosperity. The vast
majority of American companies are small businesses, including 99.7
percent of U.S. employer firms.4
They produce roughly half of the country’s GDP, and the
majority of Americans work for small businesses. Clearly, any plan
to improve our long, slow climb out of the economic doldrums that
have followed the Great Recession must include nurturing small
business development.

This development requires capital. Traditionally, small
businesses have relied on owners’ personal savings, personal
credit cards, and bank loans. Unfortunately, the community banks,
which have been the biggest providers of small business loans, are
disappearing. The total number of community banks has fallen from
more than 14,000 in the mid-1980s to fewer than 7,000
today.5 Since 1994, the share of
U.S. banking assets held by community banks has decreased by more
than a half, falling from about 41 percent to 18
percent.6 Many have been swallowed
by bigger banks, while others failed in the Great Recession. The
remaining small banks, responding to both new regulation, including
the Dodd-Frank Act, and ongoing regulatory uncertainty in the
banking sector, have tightened standards and conserved capital. The
large banks, meanwhile, have been quietly shuttering their small
business lending programs, finding them to be unprofitable. Both
the decline in community banking and the increased hesitancy among
major banks to lend to small businesses may have contributed to the
decline in small business loans from 50 percent of all bank loans
in 1995 to only 30 percent in 2013.7

The other major source of capital is the sale of securities. A
company may choose to “go public” and sell its
securities (typically stock) in the public capital markets
following a registration of the offering with the Securities and
Exchange Commission (SEC). A company may also choose to forgo the
expense and hassle of a public offering and instead opt for a
private placement or other sale that relies on provisions in the
securities laws exempting certain sales from full registration
requirements.

While selling securities can be a very attractive option, and is
almost always necessary for companies that grow to a certain size,
it has considerable drawbacks.8
The laws governing the issuance, sale, and resale of securities are
notoriously complex and can trigger significant liability,
including criminal liability, if handled improperly. Large
companies are subject to virtually the same laws and same liability
as small companies, but because much of the compliance cost is
fixed, the cost as a percentage of the total capital raised through
any given offering of securities is higher for smaller issuers.
Additionally, the trend in recent years has been to increase the
regulatory burden on many types of securities offerings.

Small companies have therefore faced a double whammy when
looking for capital: the contraction of bank lending to small
businesses and the increase of regulation in the securities
markets. In addition, while the traditional sources for capital
have remained stagnant, the diversity of business models that make
up the universe of small businesses has expanded rapidly since the
advent of the Internet. Bank lending, with its need for hefty
documentation, may simply be inappropriate for some types of newer
start-up enterprises. Small businesses need other options.

In 2012, Congress passed the Jumpstart Our Business Startups Act
(JOBS Act) designed specifically to address the capital needs of
small companies. This legislation includes a number of provisions,
ranging from a phased-in initial public offering (IPO) process to a
new crowdfunding exemption. The JOBS Act is unusual in that, in
each of its titles, it pares back regulation, allowing
companies additional freedom in pursuing capital. Neither the JOBS
Act itself nor its implementing regulation is ideal, but it
provides an excellent model for how to identify and repeal
purported “protections” that are effectively protecting
the economy from growing. It is also a tentative step toward
addressing the need for diversity in funding options that reflects
the diversity in small business itself.

What is Small Business?

What constitutes a small business is often difficult to define,
although several organizations have tried. The federal Small
Business Administration has more than 70 categories of small
businesses, with specific qualifications based on revenues and
number of employees.9 The Small
Business Act of 1953, on the other hand, defined small business
more qualitatively, as an entity that is independently owned and
operated and is not dominant in its field of
operation.10 The Internal Revenue
Service takes a more quantitative approach, defining small business
as partnerships and corporations with assets of $5 million or less,
or any sole proprietorship.11 A
commonly cited definition is any firm with fewer than 500
employees.12 The mechanic down
the street whose business has been passed down through three
generations, the law firm with five lawyers, the mom who makes
jewelry in her basement to sell online, the three college friends
building an app in a garage, and the manufacturing plant with a
hundred employees are all small businesses. These businesses differ
in size, capitalization, structure, and lifecycle. This
heterogeneity complicates the discussion of small-business capital
access because the needs of small businesses are not uniform, nor
is the suitability of different types of capital.

Whether a certain type of capital will be appropriate for a
company will depend on factors such as how the company plans to use
the capital, what the company’s anticipated growth trajectory
looks like, how the company is structured, and other factors that
are only loosely related to the company’s annual revenues or
number of employees. One important distinction is between
established companies and start-ups.

An established company may need capital to manage cash flow,
invest in advertising or new hires, or to expand. But, while the
company may grow to some extent, it is unlikely to have exponential
growth or to grow beyond the small business classification. The
established company will typically have a considerable amount of
financial documentation, including bank statements, a credit
history, and several years of revenue. In addition, owners and
management at established companies generally have several years of
experience in the field, and often many years of experience running
this particular business in this particular location.

Start-ups, on the other hand, have very little to show beyond an
idea, the skills and experience the management brings from other
ventures, and possibly a limited proof-of-concept or a small
revenue stream. While the start-up’s founders may have quite
sophisticated expertise in certain areas, the team may lack the
kind of operational and management experience necessary to launch a
successful venture. This may be especially true of the start-up
with large, public-company aspirations. Also, while an established
company may need modest amounts of capital on a periodic basis if
it is using the capital to manage cash flow, a start-up typically
needs large injections of cash at a few major inflection points
that mark the company’s biggest growth spurts.

Given the diversity of business models used by small firms,
adequate access to small business capital relies on a nimble
marketplace that can leverage new technology and innovative
solutions. This will be a marketplace that greets such innovation
warmly, and not one that stifles it under an antiquated regulatory
regime.

Sources of Small Business Capital

To understand the current strictures on small business capital
access it is necessary first to understand where small businesses
have traditionally obtained capital. Small business capital options
exist on a continuum from the easily accessible and easily
controlled, but also typically very limited, personal assets of the
owner or retained company earnings, to the difficult to access and
control, but exponentially larger assets of the capital
markets.

On the personal side, the owner may use savings and credit
cards, possibly pooling these with co-owners to amass seed
money.13 (According to a National
Small Business Association survey, 36 percent of small businesses
used personal credit cards; 18 percent received a loan from friends
and/or family in 2014.14) If
these fall short, the owners may ask friends and family for
informal loans or investments. These types of investments can prove
tricky for many new business owners. Founders unfamiliar with
securities law may not realize that asking a relative to invest in
a company is the sale of securities, typically of something akin to
common stock, and therefore puts the founders and the company at
risk of violating federal and state securities law. These
investments, while not fatal to the company, often create stumbling
blocks later on as the company grows. Future investors will likely
insist that these improperly made investments be unwound, requiring
rescission offers to the founder’s mom and dad, rich aunt,
and other family and friends who helped get the company off the
ground.

Bank lending is also common among small businesses. Loans may be
provided by banks of any size, but small banks provide a larger
proportion of loans under $1 million and under $100,000. In 2011,
banks with assets of $250 million or less accounted for 4 percent
of total U.S. banking assets, but made 13.7 percent of business
loans for less than $1 million and 13.9 percent of all loans for
less than $100,000.15 The 2014
National Small Business Association report showed that 20 percent
of small businesses received a loan from a community bank in 2014,
while 17 percent had received a loan from a large
bank.16 The process of securing a
loan can be time-consuming for the small business owner. It
typically requires the owner to complete an application and to
provide information including personal history (credit history,
criminal record, business experience), personal financial and bank
statements, the business’s credit history, business licenses,
tax returns, a business plan, legal documents such as articles of
incorporation and key contracts, as well as additional materials
that may be required by individual institutions.

Additionally, in many cases a small business will be required to
post collateral of some kind to secure the loan. If the company
owns assets, such as equipment or real estate, these may be
sufficient. If the company does not own assets sufficient to secure
the loan, the business owner may post personal assets, including
real estate such as a family home. The federal Small Business
Administration also operates programs that provide guarantees to
assist small businesses in obtaining loans for which they might not
otherwise qualify.17

Once the application has been submitted it may take the bank
several months to make a decision on whether to issue the loan. If
the application is rejected, the company will have to start the
application process anew with another bank.18 It has been estimated that the process of
applying for a small business loan can take as much as 20 hours of
work on the part of the business.19 The long delay in waiting for a decision,
plus the prospect of applying to another bank and waiting on that
bank’s decision, can make bank lending unattractive for
rapidly growing companies. Additionally, because of the hefty
documentation required by banks, a bank loan is generally a better
fit for an established company looking to grow than for a start-up
looking for seed money.

If a company is unable to access sufficient capital by drawing
on the owner’s personal assets and is unable or unwilling to
take out the types of loans described above, the company will look
for outside investment. Offerings of securities in the United
States are governed at the federal level by the Securities Act of
1933 (“the Securities Act”). In general, a company
issuing securities must register the offering with the SEC or the
offering must qualify for an exemption. Full registration with the
SEC allows a company to sell its securities to the general public
and allows buyers of these securities to sell them freely in the
secondary market. Because registration with the SEC can be
extremely costly due to the number and complexity of the required
disclosures, a company that goes public has typically grown to such
a size that it needs to sell its securities in the public markets
to raise sufficient capital to ensure its continued growth.

Once a company makes an initial public offering it becomes
subject to a further regulatory regime requiring periodic financial
disclosures—for example, the annual report or Form 10-K, and
the quarterly Form 10-Q—as well as disclosures of certain
major company events on an ongoing basis. It must also disclose
sensitive information about the company’s business model and
operations—information that can be very useful to
competitors.

As with most regulatory regimes, failure to comply carries a
range of possible penalties, opening the company and its officers,
directors, and hired experts to varying degrees of liability,
criminal and civil, both to the government and to individual
plaintiffs. Given the cost, regulatory burden, and potential
liability, a company will typically pursue an IPO only when it is
seeking a very large raise—usually in the eight- or
nine-figure range.

But a public offering is not the only way to obtain investment.
The basic principle underlying the regulation of securities in the
United States is this: any offer or sale of securities to the
public must be registered with the appropriate state and federal
regulators or qualify for an exemption. While the public
offering—one duly registered with the proper
authorities—is perhaps the best-known to those outside the
securities world, there are several exemptions that permit the
issuance of securities with only limited disclosures to the SEC and
investors. Each exemption includes its own set of rules and its own
set of pros and cons. Many of these are specifically aimed at
providing access to capital for issuers who find an IPO to be a
poor fit. The JOBS Act includes a number of changes that
specifically target exemptions attractive to small businesses with
the goal of making these exemptions more effective and more
user-friendly.

Effect of the 2008 Financial Crisis on Small Business
Capital Access

As we have seen, small businesses tend to turn to small banks
when seeking loans. The average small business loan is a few
hundred thousand dollars,20 and
more than half of small business loans in 2012 were issued by banks
with less than $10 billion in assets.21 Small banks were in decline even before the
financial crisis, but the crisis accelerated their demise. Of the
325 banks that failed during the crisis, 263, or 81 percent, were
community banks, typically defined as banks with assets under $1
billion.22 Surviving banks
tightened lending, both in response to economic uncertainty and to
pressure from regulators to maintain higher capital levels and
impose more stringent lending standards. The remaining community
banks have seen their share of small business lending shrink 21
percent since 2000.23

While some small banks have simply closed, many were absorbed by
larger banks. According to a Federal Reserve Bank of Kansas City
report, 90 percent of the 1,500 bank mergers since 2007 involved a
bank with less than $1 billion in assets.24 Although a large bank may keep its small
bank acquisitions open as branch offices, large banks’
business models are often not compatible with the realities of
small business lending. In particular, large banks, those with more
than $10 billion in assets, tend to be formulaic in their approach
to lending, using credit scores such as PAYDEX or FICO and
financial statements to make their determinations. In a large,
widely dispersed organization, such quantifiable methods of
decisionmaking are essential to ensure management can evaluate
performance and maintain control across branches. Community banks,
however, are more likely to have formed relationships with their
business clients. They are also likely to be attuned to the
community’s economic health, and therefore can assess whether
a loan applicant with a low credit score or unattractive financial
statements may nonetheless be a good credit risk.

And then there were the effects of the housing market. Although
the focus during and after the crisis has been on foreclosures and
mortgage delinquencies, plummeting home values were also
devastating to small business lending. As property values fell so
did the value of loans that could be secured by home equity, as
well as the number of houses that could support a second
mortgage.

Through the end of the recession and into the early 2010s,
options for small business capital looked very much the same as
they had for the past 75 years. Funding options included personal
savings and credit cards, loans often secured by the family home,
and access to the capital markets through channels largely
unchanged since the federal securities laws were written in the
early 1930s. But even these options were narrower than they had
been in earlier years. Credit had tightened in the crisis. Home
values were down and small banks were disappearing. Going public
had become increasingly unattractive to small companies, given the
increase in regulatory compliance cost. There were, however,
innovations underway in other sectors that would eventually make
their way into the small business capital market.

The Jumpstart Our Business Start-Ups Act of
2012

In response to tightening credit markets, especially in the
small business sector, Congress passed the Jumpstart Our Business
Startups Act in late 2011; the act was then signed into law by
President Obama in early 2012. The act is a mishmash of provisions
aimed at helping smaller companies. What is remarkable about it is
that each provision actually reduces some part of the
regulatory burden. Given the overall trend toward increasing
regulation in the financial sector, and the acceleration of this
trend coming out of the Great Recession, it is stunning that this
act was passed at all—and more stunning still that it passed
with overwhelming bipartisan support.25

The act incorporates several concepts already emerging at the
time, including most notably a new crowdfunding exemption under the
federal securities laws. Other key provisions, described in detail
below, include a modified IPO process for smaller companies,
changes to the private placement exemption, changes to reinvigorate
the exemption under Regulation A, and a provision that expands the
number of shareholders a company may have before it is required to
register as a public company. The provisions are only loosely
related to one another, but they all relax securities regulation in
ways intended to benefit small businesses.

This diversity in approaches may be the act’s greatest
strength. As discussed above, there is no dominant model when it
comes to small businesses; the category includes firms using a wide
array of models and organizational structures. The provision of
adequate capital for such varied business models will require a
broad range of capital solutions. Each of these provisions offers
something different, and valuable, to smaller businesses.

To fully understand how the act assists in capital formation, it
is useful to review each of the provisions individually. The next
several sections of this paper will walk through each provision in
turn, examining how various exemptions worked prior to the JOBS
Act’s passage, what changes the act made, and how these are
likely to play out. Each section concludes with a number of policy
recommendations aimed at making the changes initiated by the JOBS
Act more effective and removing unnecessary barriers to small
business growth.

Title I: The IPO On-Ramp

Title I of the act creates a modified IPO process, nicknamed the
“IPO on-ramp” because it offers companies the option of
scaling up their disclosure and compliance process gradually. This
provision grew out of concern that companies, especially smaller
and younger companies, were delaying IPOs or forgoing them
altogether due to increased regulatory complexity and risk. The
on-ramp is designed to make the process of going public easier for
those companies that are otherwise ready for the public markets but
that may be shy of taking the plunge.

This provision creates a new “emerging growth
company” (EGC) designation that applies to companies with
less than $1 billion in annual gross revenues and provides up to
five years of forbearance from certain reporting requirements
leading up to, during, and immediately after the company’s
IPO. 26 Among the key features of
the title are the ability to pitch the IPO to institutional
investors before filing papers with the SEC (a process known as
“testing the waters”); to initiate the IPO process
confidentially; and to opt out of certain Sarbanes-Oxley and
Dodd-Frank provisions related to accounting disclosures and
executive pay disclosures, respectively. The provision also permits
research analysts employed by the underwriter to publish research
reports immediately upon the earnings release, instead of requiring
the analysts to wait a specified number of days.

Given the $1 billion cap, the EGC designation applies to a
number of companies that few would consider to be
“small” businesses. In fact, companies qualifying as
EGCs include the vast majority—80 percent—of companies
that have gone public since the on-ramp went into effect in 2012.
The on-ramp may therefore best be understood as a measure to
increase the attractiveness of IPOs in general, although several of
its provisions are especially appealing to smaller companies.

The IPO on-ramp, unlike other provisions in the JOBS Act,
required no implementing rules before becoming effective. Although
it has been only three years since the act was passed, there are
indications that it has succeeded in its goal of increasing the
number of IPOs, with the greatest increase among smaller firms and
especially among biotechnology firms. Because the equities market
has been so bullish in the years since the JOBS Act was passed, it
is difficult to say with certainty how much of an effect the act
had independent of market forces. However, some evidence supports
the conclusion that, controlling for market conditions, the IPO
on-ramp accounts for an increase of 21 IPOs, or 25 percent, over
pre–JOBS Act levels.27

The on-ramp’s appeal was intended, in part, to derive from
the ability to pursue a more streamlined disclosure
process.28 The average cost of an
IPO has been estimated at about $3 million, with the bulk of this
expense going to the lawyers and accountants who prepare the filing
documents .29 Whether the
offering is for $10 million or $100 million, the work required to
prepare these materials remains relatively fixed. The ability to
opt out of some legal disclosures was intended to reduce the
compliance cost and therefore render those costs a smaller
percentage of the overall IPO cost.

Ultimately, however, the reduced disclosure has not been the
provision’s most attractive feature. Despite the fact that
EGCs can, for example, file only two years of audited financial
statements instead of three, in 2013 a small majority of companies
opted to provide a full three years instead.30 Additionally, some research has shown that
companies that opt for reduced financial disclosure see their IPOs
underpriced compared with other issuers.31 It therefore appears that the market itself
has demanded a higher level of disclosure, providing a useful test
case to demonstrate both what information is truly valuable to
investors and the ability of the market to induce such disclosures
without regulatory coercion.

On the other hand, the confidentiality provisions have been
enormously popular. Uptake on the option to file confidentially has
been high, at 88 percent overall since the JOBS Act was signed into
law, with many firms also taking advantage of the opportunity to
test the waters with institutional investors.32 These provisions provide several benefits.
First, preparing for an IPO and filing the necessary papers with
the SEC is incredibly expensive. If a company is able to test the
waters with institutional investors first, it can spend the money
for the IPO with confidence that the IPO will be successful.
Second, public filing exposes many of the company’s secrets,
including business model, revenue, expenses, information about its
products, and management’s view of risks facing the company.
A company choosing to go public has calculated that exposing this
information publicly, including to its competitors, is worth the
opportunity to access the capital markets. If the IPO flops,
however, the company has exposed itself for nothing.

In some ways, the confidentiality provisions of the IPO on-ramp
seem counterintuitive. The very nature of a public company is that
it cannot be secretive. Even without SEC-mandated disclosure, a
publicly traded company would need to provide visibility about its
operations to shareholders and would-be investors. However, by
shifting certain disclosures—including most notably the fact
that the company is contemplating an IPO—to just a few weeks
later, the company is able to conduct a more accurate cost-benefit
analysis regarding the utility of an IPO.

Even though the smallest and youngest companies will not be
using the IPO on-ramp any time soon (and some may never opt to go
public), the benefits of an improved IPO process inure to companies
at every stage. A robust IPO market has several advantages. It
reflects economic growth and provides assurance that regulatory
barriers are not smothering activity. It has a democratizing effect
on wealth-building by enabling non-accredited investors (also known
as retail investors) to participate in a company’s explosive
early growth. And it lowers the cost of capital, including early
stage capital, by providing liquidity for investors. A sluggish IPO
market can make it especially difficult for start-ups to raise
cash. Such early investment essentially locks down investors’
money. The longer the path to an IPO, the longer investors must
wait, and the longer the lag until they are able to recover their
cash and invest in a new venture. The IPO on-ramp is therefore
especially important to the start-up model small business that must
raise cash in a few large injections to make the leap from one
stage of growth to the next.

The IPO on-ramp ultimately makes only minimal changes to the IPO
process. After five years of going public, a company that uses the
on-ramp will have the same reporting and compliance requirements
that any other public company has.33 Although regulation generally operates as a
ratchet, moving only toward more regulation, in this case
regulation was loosened, with limited ill effects and with
promising indications of positive results.34

Policy Recommendations

The IPO on-ramp provides not just a single alternative IPO
process, but a menu of options from which an issuer may choose. The
selection process provides valuable insight into what features are
useful to issuers and what features are irrelevant given market
pressures. The fact that the confidentiality features appear to be
especially attractive to biotechnology companies, who face
substantial risk in exposing company secrets during the IPO
process, suggests that a one-size-fits-all approach to disclosure
may be harmful to capital formation.

It would benefit all public companies, investors, and the
American economy if the SEC required only those disclosures that
provided valuable information to the market. There is currently no
mechanism to systematically revisit and evaluate the effectiveness
of the disclosures the SEC requires of public issuers. The
effectiveness and lack of evidence that fraudulent offerings
increased following the introduction of Title I of the JOBS Act
shows that parts of the current mandatory disclosure regime are
unnecessary.35 What other parts
are equally useless? What serves only as a drag on the economy? A
good start to finding out would be a one-time review by the SEC of
the current disclosure regime accompanied by a commitment to repeal
any requirements that are not shown to be effective. A better start
would be to commit to repeating this process on a regular basis to
ensure that whatever disclosures the SEC requires are indeed
providing value to the market.

Title II: Private Placements

Of the many exemptions from registration available under the
federal securities laws, the exemption for private placements is
the 800-pound gorilla. This exemption allows issuers to offer
securities to a select group of investors, known as
“accredited” investors, comprised principally of
institutions and wealthy individuals. While the public capital
markets receive the most attention, private placements are a key
driver of capital access for companies of all sizes. Although the
rules for their use are complex, the process is simpler and cheaper
than the process for a public offering. While public companies can
and do use private placements, the majority of these offerings tend
to be in the $1–5 million range, indicating wide usage by
small, privately-held companies. Private placements are
the way that small companies sell securities to raise
capital.

Title II of the JOBS Act liberalizes both the way in which a
company doing a private placement may advertise its offering to
potential investors and the way in which securities bought in a
private placement may be advertised in the secondary market. Given
the large role private placements play in funding small companies,
principally through investment by venture capital funds (VCs) and
angel investors, but also in friends and family rounds, these
changes may prove significant.

How Private Placements Are Used

The securities laws make a distinction between
“public” and “private” offerings. Public
offerings are those made to the general public. Private offerings
are those made to a more select group of potential investors.
Finding the line between public and private can be tricky—how
select does the select group have to be for the offering to qualify
as non-public? The vast majority of private placements therefore
use a set of rules set out in the SEC’s Regulation D that
provide what is known as a “safe harbor.” A safe harbor
is a legal provision that states that certain conduct will be
assumed not to violate a particular law. It is the rules that make
up this safe harbor (and, very specifically, how the rules define
“non-public”) that the JOBS Act changes. In order to
understand the impact of the changes in Title II of the JOBS Act it
is necessary first to understand something about how Regulation D
works. Although Regulation D includes several rules with varying
requirements under which an offering may qualify for the exemption,
the most commonly used, by far, is Rule 506.36

The sine qua non of the registered public offering is its large
volume of mandatory disclosures. A company preparing for an IPO
often spends millions of dollars compiling specific pieces of
information required by law to be provided to the SEC and the
public in conjunction with the sale of its securities. Thereafter,
the company must spend millions more dollars providing updates on
this information to the public (and the SEC) on a quarterly and
annual basis. The SEC has estimated that the average cost of
continuing annual regulatory compliance for public companies was
$1.5 million in 2014.37 The
purpose behind these disclosures is to ensure that the investing
public has the information it needs to make informed investment
decisions.

The presumption underlying Rule 506 is that certain investors,
because of wealth or access to information, do not need the
protections of the disclosures required in a registered
offering.38 And an offering to
them may therefore be done under the private placement exemption.
Under 506(b), the securities may be sold to no more than 35
“non-accredited investors” and an unlimited number of
“accredited investors.” Accredited investors include
those investors who are presumed able to “fend for
themselves” in obtaining necessary information from the
company to make an informed investment decision.39 These investors include institutional
investors, a director or executive of the issuer, or a wealthy
individual whose assets (excluding primary residence) exceed $1
million or who, alone, earns more than $200,000 annually or
$300,000 annually jointly with a spouse.40

Non-accredited investors are individuals who nonetheless have
“such knowledge and experience in financial and business
matters that [they are] capable of evaluating the merits and risks
of the prospective investment, or the issuer reasonably believes
immediately prior to making any sale that such purchaser comes
within this description.”41
Additionally, sales to these individuals must be accompanied by
significant disclosures outlined in Regulation D.42 The rationale for these disclosures is
that, unlike accredited investors, non-accredited
investors—even those who have “experience in financial
and business matters”—are presumed to lack the
financial sophistication necessary to request the relevant
disclosures from the issuer.43
Because the purpose of most offerings under Rule 506 is to avoid
costly disclosures, these offerings are typically limited to
accredited investors in order to dispense with the obligation of
providing the mandated disclosures for non-accredited
investors.44

Unlike other exemptions in the securities laws, there is no
limit on the amount of money an issuer can raise using Rule 506 of
Regulation D, and it is available for use by public companies.

In addition to restricting who may buy the securities, Rule 506
restricts how an issuer may contact potential buyers. Before Title
II of the JOBS Act became effective, issuers relying on Rule 506
were barred from “general solicitation.”45 In interpreting what constitutes a general
solicitation, the SEC has taken a broad view. The rule states that
general solicitation includes, but is not limited to, “any
advertisement, article, notice or other communication published in
any newspaper, magazine, or similar media or broadcast over
television or radio; and … [a]ny seminar or meeting whose
attendees have been invited by any general solicitation or general
advertising.”46 Generally,
if the issuer has a “preexisting and substantial
relationship” with anyone to whom the securities are offered,
the SEC will find that there was no general solicitation.

One of the major challenges for companies raising capital
through a private placement is attracting investors. A large,
established company will have a ready network of brokers and
interested investors, something smaller companies, and small young
companies in particular, lack. The restrictions on general
solicitation therefore put many companies in a bind—how to
find accredited investors if the company is barred from advertising
for them? There have traditionally been a few options. A company
whose owners have wealthy friends or family can tap the
owners’ personal networks. There is also considerable
informal investment in the small business world, much of which is
not in compliance with the securities law. Small business owners
may obtain investment from friends and family who are not
accredited, often without the small business owner or the investors
realizing they are engaging in a securities transaction and
certainly without knowledge that they are doing so in violation of
the law.

Issuers can also use a middleman: a broker can act as an
intermediary to connect issuers with investors. Brokers,
knowledgeable about their client’s assets and therefore
whether they qualify as accredited investors, and having a
preexisting business relationship with their clients, may contact
clients who may have an interest in certain private placements the
broker knows are seeking investors. However, brokers typically
receive a portion of the sales proceeds as a fee, and most small
offerings are too small to attract the interest of intermediaries;
only 13 percent of Regulation D offerings from 2009 to 2012
reported using a broker.47

There also are investors who intentionally seek out promising
new companies with the intention of providing funding via private
placement. Venture capital funds are perhaps the best-known of this
type of investor. Venture capital firms seek to invest in
high-growth companies that can bring an IPO to market in a few
years, providing a substantial return on investment.

These companies are generally highly scalable, offering
exponential growth if successful. Obtaining VC funding is something
of a Holy Grail in the start-up world, but such funding is
difficult to obtain. In 2010, for example, 505,473 new companies
were incorporated in the U.S. but only 1,095 companies received
venture capital funding.48
Because the funds are looking for a large return, given the
riskiness of the investment, a business model that is not
particularly scalable will not be attractive to venture
capital.49

Moreover, some companies do not want venture capital. In
exchange for what is a large investment, given the relatively small
size of the company, VC typically takes a considerable equity
stake, diluting existing shareholders (usually the company’s
founders). One corporate development consultant estimated the
average VC equity stake to be approximately 70 percent of the
company.50 Venture capitalists
also take a hands-on approach to managing their investment, often
taking at least one seat on the company’s board of directors
and actively guiding the company’s management.

For some start-ups, this involvement is a feature, not a bug. If
the company’s founders are inexperienced, either because of
youth or general unfamiliarity with the ins and outs of running a
company, they may welcome the guiding hand of VC’s
well-seasoned executives. But other founders may prefer to keep a
firm grip on the company’s reins and may therefore eschew VC
interference in day-to-day operations and strategic planning.

In addition to the considerations above, venture capital may be
inappropriate for a company due to the stage in its development.
Because VC is generally looking for an exit in the near
term—IPOs backed by venture funding in 2010 had received six
years of support on average—these funds are typically
interested in what might be called mature start-ups, those
companies that are likely to have their biggest growth ahead of
them but that have shown their mettle through initial growth and
development of a healthy revenue stream.51 A very young company, one that has yet to
launch its product or generate any revenue, would generally be too
immature for VC investment.

Companies seeking very early stage investment, often called
“seed money,” may turn to “angel”
investors. Angels are individuals, or small groups of individuals,
who invest smaller sums of money in brand new ventures. Where a VC
might invest several million, an angel might invest $50,000 or
$100,000, or even as little as $30,000. While all investors are
looking for a return on investment, angels are generally also
motived by an interest in helping new companies and fostering
entrepreneurship. Angels themselves are frequently successful
entrepreneurs who see this form of investing as a way to give back
by identifying and supporting promising new entrepreneurs.

The form of an angel investment may also differ from the form of
VC investment. Whereas VC firms almost always take an equity stake,
an angel may take equity or debt, but often prefers convertible
debt, which incorporates some of the most attractive features of
each.52 The amount of guidance an
angel provides will vary with the angel-company relationship. Some
angels are interested in providing a great deal of expertise and
guidance (which many companies are thrilled to have since such
expertise may be extremely expensive if a company were to buy
comparable services), while others are happy to take a more
hands-off approach. Although angel investment can be a boon to new
companies, it, like venture capital, can be difficult to secure. In
2010, 61,900 companies received angel investment, representing a
little more than 12 percent of the total new businesses started
that year, with an average investment of about
$325,000.53 Angel investing has,
however, been on the rise. In 2006, for example, the Bureau of
Labor Statistics reported 667,341 new enterprises; but only 51,000
received angel funding, or about 7.6 percent.54

Angel investing has existed in some form throughout time.
Beginning in the 1990s, however, angels began to form groups to
seek investment opportunities. By forming a network, angels can
more effectively connect with entrepreneurs seeking their help.
With the advent of the Internet, some of these angel networks went
online. To comply with the pre–JOBS Act ban on general
solicitation, websites listing investment opportunities required
investors to register and confirm their accredited investor status
before viewing the offerings.

The result of the restriction on advertising has been to require
a relationship-based approach to selling securities through private
offerings. People must actually know people in order for the sales
to work. This has resulted in great geographic concentration.
Investors tend to invest in companies geographically close to them.
The investors, brokers, and issuers have therefore all been grouped
close together, historically in California, New York, and
Boston.55 This means that
innovations in other parts of the country may be starved of funds
for no reason other than geographic accident. It also means that
society at large has been deprived of new inventions and the
benefits they bring only because of where the inventors lived.

Secondary Market for Securities Sold in Private
Placements

The secondary market for securities sold through a private
placement is also quite limited. The federal securities laws
require not only that offerings be registered, but that securities
themselves be registered as well, unless, as with offerings, they
qualify for an exemption. Securities sold through a public offering
are registered as part of the offering process. But securities
bought through a private placement are not registered, and are
therefore “restricted.” They cannot be resold unless
the sale qualifies for an exemption.56 This restriction increases the price of
capital raised through a private placement. A less liquid security
will carry a higher premium to entice investors to effectively lock
up their money.

One exemption from the registration requirement is for
“transactions not involving an issuer, underwriter, or
dealer.”57 This seems like
an easy solution—wouldn’t most investors, trading
amongst themselves, fall into this category? Unfortunately, no. The
securities laws define “underwriter” so broadly that
steering clear of the underwriter designation has made trading
restricted securities very tricky to navigate. The Securities Act
includes in its definition of an underwriter “any person who
has purchased from an issuer with a view to … the
distribution of any security[.]”58 The intent behind this interpretation is
clear: if a security could be bought in a private placement and
immediately resold to any investor, including any member of the
public, the distinction between public and private offering would
evaporate. But how to distinguish between the investor who bought a
security for investment and one who purchased it with a “view
to [its] distribution”?

Because this definition requires the SEC to peer into the mind
of the investor to determine whether the investor bought the
security with “a view to [its] distribution,” the law
has developed to use certain behaviors as a proxy for determining
what the investor’s intent may have been at the time of
purchase. Most notably, the SEC has found the length of time
between the initial purchase from the issuer and the sale in the
secondary market to be relevant to the initial purchaser’s
intent.59 To further remove
uncertainty surrounding the underwriter designation, the SEC issued
a rule in 1972 that creates a safe harbor for the resale of
securities issued under the private placement exemption. Under Rule
144, an investor who holds a restricted security for six months if
the company is a reporting company or a year for other companies
may resell the security without being deemed an underwriter.

While Rule 144 provided some liquidity for restricted
securities, a holding period of six months or a year is still a
burden. Also, if the intent behind the underwriter designation for
shorter holding periods was to prevent the security from immediate
transfer into the hands of retail investors, it would seem that
sales between accredited investors should be permitted. In 1990 the
SEC issued Rule 144A. This rule allows restricted securities to be
offered in the secondary market to “qualified institutional
buyers,” or QIBs, without a holding period.60 Qualified institutional buyers are, in
general, institutional investors that own and invest on a
discretionary basis at least $100 million in securities, and
dealers who own and invest on a discretionary basis at least $10
million in securities.

Note, however, that the rule requires restricted securities not
only to be sold only to QIBs, but also to be offered only
to QIBs. To understand the difficulty this restriction has imposed,
it is important to understand what, exactly, “offer”
means.

The definition of “offer” under federal securities
law is notoriously broad. The Securities Act of 1933 states that
“[t]he term … ‘offer’ shall include every
attempt or offer to dispose of, or solicitation of an offer to buy,
a security or interest in a security, for
value.”61 This already
broad definition has in turn been interpreted broadly by the SEC. A
communication need not even expressly offer the securities for sale
for it to be considered an offer. According to the SEC:

The publication of information and statements, and publicity
efforts, generally, made in advance of a proposed financing,
although not couched in terms of an express offer, may in fact
contribute to conditioning the public mind or arousing public
interest in the issuer or in the securities of an issuer in a
manner which raises a serious question whether the publicity is not
in fact part of the selling effort.62

Google famously had to delay its IPO because an interview its
founders Larry Page and Sergey Brin gave to Playboy
magazine arguably “contribut[ed] to conditioning the public
mind or arousing public interest” in the IPO.

So, private placements, while vital to companies’ ability
to access investment, nonetheless present some traps for the
unwary. Moreover, many of the restrictions focusing on
offer versus sale provide minimal benefit, if
any, but have imposed substantial costs on issuers, investors, and
on our economy as a whole, which benefits from companies’
ability to obtain the capital to grow.

JOBS Act Changes to Regulation D

Title II of the JOBS Act radically reforms the rules for
solicitation of investors in both the primary and secondary markets
for private placements. It directs the SEC to issue new regulations
lifting the ban on general solicitation for Rule 506 offerings,
specifically “to provide that the prohibition against general
solicitation or general advertising … shall not apply to
offers and sales of securities made pursuant to section 230.506,
provided that all purchasers of the securities are accredited
investors.”63 It also
directs the SEC to change Rule 144A to allow offers to non-QIBs:
“to provide that securities sold under such revised exemption
may be offered to persons other than qualified institutional
buyers, including by means of general solicitation or general
advertising, provided that securities are sold only to persons that
the seller … reasonably believe[s] is a qualified
institutional buyer.”64
This means that private placements and securities sold in private
placements can be offered, that is, advertised, anywhere.
Television, billboards, banner ads on websites, cold calls,
sky-writing airplanes flying over crowded beaches—it’s
all okay. (Although, of course, these changes apply only to offers;
actual sales remain restricted to accredited investors and
QIBs.)

In September 2013, the SEC adopted final rules implementing
these changes. Under these rules, the SEC created two versions of
Rule 506 offerings: the traditional Rule 506 offering, which
retains the prohibition on general solicitation and permits a
limited number of non-accredited investors; and a new offering
under Rule 506(c), which permits general solicitation but requires
that issuers sell only to accredited investors.

Under the traditional Rule 506 offering (now named a
“506(b)” offering to distinguish it from the new Rule
506 offering, which appears under Rule 506(c)), investors have
typically self-certified their status, via questionnaire or other
method. And an issuer, assuming it has a reasonable belief that the
investor is indeed accredited, can rely on an investor’s
assertion that he or she meets the income or net-worth
requirements. Under Rule 506(c), however, issuers must take
reasonable steps to verify accredited investor status, resulting in
more work for the issuer. The SEC has provided a nonexclusive list
of methods that an issuer might use to verify that an investor has
the requisite income or net worth; these include reviewing tax
documents, bank statements, a report from a nationwide consumer
reporting agency, or obtaining written confirmation from an
attorney, accountant, broker-dealer, or registered investment
adviser.

Result of JOBS Act Changes to Regulation D

As the new rules implementing these changes went into effect
only in late 2013, it is difficult to predict definitively the
effect they will have on the private market. Although the
rules’ implementation was much-touted in certain corners of
the Internet,65 many small
businesses remain unaware of the changes.66 Recent data suggest that fewer than 10
percent of Rule 506 offerings are conducted under the new
506(c).67 Additionally, even with
the introduction of online platforms to connect investors with
entrepreneurs, the investment process for many investors remains a
personalized one. While many angel investors now use platforms to
find entrepreneurs, online investment platforms take the place of
introductions, not relationships. The process is not unlike online
dating. The Internet enables people to search for and connect with
others looking for a romantic relationship, but the relationship
itself tends to take place offline, in real life. Similarly, angel
investors can search for and connect with early stage companies
online, but often prefer to meet and talk with the company’s
founders face-to-face before making an investment.

The changes may, however, expand the population of private
placement investors. Not every investor who qualifies as accredited
will seek out an angel network to join. But such investors may be
drawn in by advertising now permitted by the new rules. This may
provide opportunities for those small businesses that can leverage
existing relationships to raise funds, expanding the value of those
connections.

Consider, for example, a luxury-good purveyor who has an
established base of clients who are familiar with the product and
with the company itself. The company may decide to seek investment
from its customers, whom it knows include a number of individuals
with the requisite income or assets and who may be interested in
investing in this company, although they may not have
sought out such investments in the past. Or consider other built-in
investor audiences: alumni networks, local community members,
subscribers to a niche-interest publication. Investing platform
North Capital Private Securities recently announced that it will be
using an online Rule 506(c) offering to raise $30 million to
partially fund a giant Ferris wheel to be built on Staten
Island.68 These investors will
not be angels, in that they are unlikely to provide the mentorship
that often accompanies an angel investment, but they may be
interested in supporting a company affiliated with their personal
interests.

There is also the possibility of developing Web-based platforms
geared toward specific interests. The platform 1031 Crowdfunding,
for example, permits investors to find one another to exchange
investment real estate to take advantage of a provision in the tax
code.69 Finally, although many
existing angels may prefer to meet company executives in person
before investing a sizeable sum, some may take advantage of the
efficiencies of online investing to invest much smaller
amounts—a few hundred dollars perhaps—in companies
purely via online platforms. While $500 is not going to get any
company off the ground on its own, multiple $500 investments could
do the trick.

While the new 506(c) offering may provide greater opportunities
for both investors and issuers, there are reasons a company may opt
to select the traditional 506(b) offering instead. First, the
issuer’s relationship with the investor can be somewhat
different in a 506(c) offering than in a 506(b) offering. On the
one hand, the issuer in a 506(c) offering will have access to
documents and information about the investor’s financial
situation that a 506(b) issuer would not have. Because 506(b)
allows investors to self-certify that they are accredited, issuers
would have no cause to review investors’ tax or financial
documents, documents that must be reviewed by a 506(c) issuer
looking to use the rule’s safe harbor. On the other hand, the
issuer in a 506(c) offering ultimately may have less information
about, and control over, the investors than a 506(b) issuer would
have. Consider the method each uses to solicit investment. In the
506(c) offering, the issuer is likely to use the Internet or some
other method of general solicitation (this is, after all, the
raison d’ȇtre of the 506(c) offering). The issuer is
using this method of attracting investment specifically because it
allows the company to reach investors otherwise unknown to it.
While this provides greater reach, it also means that the investing
relationship will not be quite as close as the relationship between
an issuer and investor who either already had a preexisting
substantial relationship themselves or were introduced through a
trusted intermediary. One of the advantages of being a
privately-held company is the ability to control who owns you;
choosing general solicitation as a means of finding investors risks
ceding this control.

Second, the issuer in a 506(c) offering must choose what to
disclose publicly as part of its general solicitation, navigating
between the Scylla of exposing company secrets to a wide audience
(including competitors) and the Charybdis of committing securities
fraud. Any offering of securities, including one made pursuant to
Rule 506(c), is subject to Rule 10b-5, the federal securities
laws’ catch-all fraud provision. This rule makes it illegal
to:

Employ any device scheme or artifice to defraud, to make any
untrue statement of a material fact or to omit to state a material
fact necessary in order to make the statements made, in the light
of the circumstances in which they were made, not misleading, or to
engage in any act, practice, or course of business which operates
or would operate as a fraud or deceit upon any person in connection
with the purchase or sale of any security.70

While it requires some attention to detail, most issuers acting
in good faith can refrain from making untrue statements of material
facts. It is trickier to ensure that disclosures do not leave out
necessary information, the omission of which may make them
misleading. To see the difference, consider, for example, a
manufacturing company with two factories. It would be plainly
misleading to state that the company had three factories when it
had only two. But what if the second factory was currently shut
down due to a broken piece of machinery that would cost $1 million
to replace? Now the company, if it discloses the existence of two
factories (where clearly manufacturing capability is a material
fact), must also disclose the fact that one is currently shut down
and will require $1 million to fix so that its statements are not
misleading.

The traditional 506(b) private placement does not require any
specific disclosures if the offering is limited to accredited
investors. But the investors typically receive a private placement
memorandum (PPM), which includes all the information the issuers
feel the investors would want to know before investing in the
company. While the information can be quite sensitive, it is not
made publicly available and is provided only to those eligible to
invest in the company. As discussed in the context of the IPO
on-ramp earlier, the ability to keep information secret from
competitors is one of the great advantages of remaining a
privately-held company.

It may be that issuers conducting a new 506(c) offering will
choose to provide interested investors with a private placement
memorandum. But it is unlikely that they will want to make it
widely available. While any company conducting any kind of offering
can fall afoul of Rule 10b-5, it will be especially challenging for
a company to provide sufficient information to entice investors
through general solicitation while simultaneously ensuring the
information is not misleading due to an omission.

As with Title I, the changes that Title II makes to the
securities laws are relatively small—506(c) offerings are
still available only to accredited investors, and securities sold
through these offerings are still restricted. But they provide a
flexibility that will enable new companies that might have
otherwise been shut out of the market for reasons unrelated to the
quality of their business models to access capital. And they allow
investors new opportunities and options in allocating their funds
and permit those outside the venture capital hot spots to influence
the development of new products and services through investment.
The 506(c) offering may appeal equally to an established company
and to a start-up. Most important may be the company’s
ability to convert existing relationships into investment or to
appeal to an audience broader than what has traditionally been the
source of early stage investment. While less glamorous than Title
III, which creates the new crowdfunding exemption, Title II may
result in a greater impact on capital access.

Policy Recommendations

The current definition of accredited investor is too limited.
The best solution would be to do away with the
accredited/non-accredited distinction entirely, and permit
individuals to make their own decisions about how they want to
spend their money. In the alternative, the accredited investor
standard should be revised to ensure it reflects an
investor’s actual ability to evaluate an investment. Wealth
alone has little bearing on whether a person is well-informed, or
even well-advised, on investment matters. Even if it did, using a
fixed number with no reference to variances in cost of living gives
preference to people living in certain parts of the country. It
also favors age over other measures of experience. Under existing
law, for example, a retired physician living in New York City might
be able to invest in a start-up developing new mining technologies
while a young mining engineer, who is much better informed about
mining itself and about the industry in general, would be
excluded.

The current method of calculation also excludes the primary
residence. This recent change means that two people, each with say
$2 million, would be treated differently if one chose to buy a $1.5
million house and invest the rest, while the other decided to rent
a house and invest the whole $2 million. Each would have the same
net worth, but the investment the first individual made in a house
would not be considered in the same way that the second
individual’s first $1.5 million investment would be
considered.

The accredited investor calculation should be revised to again
allow investors to include the value of the primary residence.
There should be an additional method of qualifying as an accredited
investor that allows an individual to demonstrate knowledge of
basic finance and investing concepts. Finally, an individual should
be able to invest in specific offerings upon a showing that the
investor has knowledge of the issuer’s industry. A certain
amount of work experience in that industry, a professional
qualification, or a university-level degree in a field directly
related to the issuer’s industry would be presumed to confer
the relevant knowledge.

Title III: Investment Crowdfunding

Title III of the JOBS Act is by far the most ambitious of the
act’s titles. While every other title simply tweaks elements
of existing securities law, Title III, through a collection of
interwoven exemptions, creates an entirely new kind of offering.
Included in its exemptions are: an exemption for the offering from
registration under Section 5 of the Securities Act of 1933 even
though it is an offering to the public; an exemption for the
company from registration under the Securities Exchange Act of 1934
even if the company would otherwise trigger the requirement that it
register once it exceeds a certain number of shareholders of
record; and exemption from registration as a broker-dealer for a
new type of entity, the “funding portal.” The novelty
of this title, and the genesis of this collection of exemptions,
have created a number of challenges for the SEC in developing
implementing regulations—challenges that, to a large extent,
remain unresolved.

Origins of the Crowdfunding Exemption

The genesis of a crowdfunding exemption was not the SEC or even
the financial industry. Its origins lie in the tech start-up world.
In 2006, a new version of an old concept emerged, built on the
Internet’s ability to radically reduce transaction costs
across a wide geographic area. In its current incarnation, the
concept is called “crowdfunding.” In general,
crowdfunding refers to a means of raising funds by which small
amounts are solicited from a large number of people.

The concept predates the Internet by hundreds of years. Long
before the Internet was developed, people took up
“subscriptions,” commitments to provide small amounts
of money, to support public projects. Arguably the Statue of
Liberty itself stands in New York Harbor thanks to a
“crowdfunding” project.71 The Internet, however, has made this method
easier to use, as reaching hundreds or even hundreds of thousands
of people has become extremely cheap. A number of platforms have
sprung up to facilitate the process. The most prominent is
Kickstarter, followed closely by Indiegogo and Rockethub, among
others. While these platforms tend to focus on actual projects,
others such as GoFundMe allow individuals to seek funding for
almost any purpose.72

In recent years, even before passage of the JOBS Act, a number
of companies have turned to crowdfunding to obtain seed money.
Because of existing securities regulation, however, companies are
currently restricted in how they may use crowdfunding. They may
solicit money from individuals, and they may provide benefits in
exchange for that money—but not offer investment. Successful
crowdfunding campaigns have included preferred status on a waitlist
for the forthcoming product, a T-shirt, or a handwritten letter of
thanks from the company’s founder.73 They may not, however, offer a means by
which investors can receive a return on investment.74 Given the nature of the rewards that
companies may offer, the type of company that can currently use
crowdfunding successfully is limited. Generally only a company with
a certain level of charisma, either because it offers an innovative
consumer product or because it exudes a coolness that people find
attractive, will be successful in attracting this type of
capital.

Frustrated by the inability to use crowdfunding more broadly,
several entrepreneurs initiated a campaign to create an exemption
to allow investment crowdfunding for small businesses.75 With the assistance of the Sustainable
Economies Law Center, a nonprofit organization focused on
developing local economies, they submitted a proposal for
rulemaking to the SEC.76 Other
entrepreneurs drafted proposed legislation, which they presented to
lawmakers in late 2010.

This was when two very different worlds—the
entrepreneurial world and the deeply complex world of SEC
regulation—collided. Part of the appeal of crowdfunding is
its grassroots nature. Early proponents of investment crowdfunding
remarked on how ludicrous it was that such a simple form of
investment was illegal.77 The
investment crowdfunding concept was therefore intended to be
extremely simple. The proposal submitted to the SEC envisioned a
$100,000 cap on the offering and a $100 limit per investor. It
suggested that issuers might be a local café looking to
expand, a community garden, or a bookstore interested in adding a
stage and public address system for small performances—all
very small businesses whose owners may not have a high level of
financial sophistication. Embedded in the concept was the idea that
issuers could do a crowdfunded offering without the raft of legal
and financial experts typically needed for even a small private
offering, and certainly without the army of experts employed by the
issuer planning an IPO.

How the Crowdfunding Exemption Will Work

Unfortunately, given the complexity of the federal and state
securities laws and their attendant regulations, even a simple
exemption for a very simple type of offering cannot ultimately be
done simply. Although the exemption is entirely new, it is built
into the same complex securities law framework that has existed for
the last 80 years. The version of the exemption that was ultimately
included in the JOBS Act will require, for most issuers, some
professional guidance to navigate successfully. This may be its
downfall. There is a $1 million cap on any offering using this
exemption. Given the cost of professional assistance, any money
raised under this exemption becomes extremely expensive and most
issuers will likely find other exemptions more attractive.

The new exemption works as follows. A company may offer up to $1
million in securities, whether debt, equity, or some combination,
to the general public over the course of one year without
registering the offering with the SEC, provided the offering meets
all of the requirements to qualify for the exemption. These include
the following: the issuer may not be a public company and must be a
U.S. entity. The issuer must provide certain information to the
SEC, including the issuer’s name and address, the identities
of its officers and directors, and a description of the
issuer’s business plan. It must also disclose its financial
condition, provide financial statements and information regarding
its capital structure, and disclose how much it wants to raise,
what it will do with the proceeds, and what the price of the
securities will be. The issuer must meet its full funding goal for
the raise to close; if it fails to meet its target by a set
deadline, no sales occur.

After the offering closes, the issuer must comply with ongoing
reporting requirements. It must make annual disclosures to the SEC
and its investors regarding business operations, and must produce
its financial statements.

The exemption also imposes certain restrictions on investors.
Prospective investors must pass a financial literacy test, which
must include an acknowledgment of the fact that the investor could
lose the entire investment. The amount any one investor may invest
in crowdfunding securities in one year is capped at an amount based
on the individual’s annual income and net worth, but
investment for any investor, regardless of wealth, is capped at
$100,000 annually.

Finally, the offering must be made through either a registered
broker or dealer, or through a new entity termed a “funding
portal.” Under the Securities Exchange Act of 1934, any
person “engaged in the business of effecting transactions in
securities for the account of others,”78 or “engaged in the business of buying
and selling securities” for that person’s own
account79 is a broker or dealer
and therefore must register with the SEC.80 Registration as a broker or dealer is an
onerous process. It requires registration with the SEC itself and
with the Financial Industry Regulatory Authority (FINRA). While
nominally a private entity, FINRA functions in a quasi-governmental
role, writing and enforcing a number of rules for the financial
services industry, the violation of which can result in loss of
license and fines. Among FINRA’s rules for broker-dealers are
that broker-dealers and their employees must pass certain
examinations, written and administered by FINRA; that the
broker-dealer must maintain established capital levels; and that
the broker-dealer is subject to a fiduciary duty standard in
certain transactions and relationships, exposing the broker-dealer
to substantial litigation risk.

The JOBS Act provides an exemption from these requirements for
persons “acting as an intermediary in a transaction involving
the offer or sale of securities for the account of
others”81 as long as those
transactions are exclusively within the crowdfunding exemption. But
the funding portal loses its designation—and therefore its
exemption—if it provides investment advice; solicits
purchases, sales, or offers for the securities on its platform;
pays commissions for the sale of the securities it has listed; or
holds or manages investor funds or securities.

This is not to say that, by virtue of being exempt from
registration as brokers or dealers, funding portals are
unregulated. In fact, Title III clearly intends for funding portals
to act as gatekeepers for the crowdfunding industry. They must
register with the SEC and with FINRA, provide investor education,
ensure that investors do not exceed the individual investment cap,
and protect confidential information. They are also given the task
of ensuring that funds are not released to issuers until and unless
they have reached their funding target.

Then there are the anti-fraud provisions, which apply both to
funding portals and to issuers. Both are subject to the
wide-ranging liability of Rule 10b-5. Additionally, the JOBS Act
includes a provision creating a new cause of action specific to
crowdfunding offerings, imposing liability on the issuer for a
material misstatement or omission of a required statement. Once
again, the securities laws interpret a term so broadly as to create
a number of regulatory hurdles. Although “issuer” would
seem to apply only to the company actually issuing the securities,
in fact the securities laws define issuer to include the company,
its directors and partners, its principal executive, and its
financial and accounting officers.

The definition of “issuer” also includes “any
person who offers or sells the security in such
offering.”82 The Supreme
Court has construed the term “issuer” broadly enough
that a funding portal arguably falls within the definition of
“seller” in this context.83 Unlike Rule 10b-5, which requires a finding
of scienter, or an intent to defraud, the new provision in
the JOBS Act requires no such intention; if there is a finding that
there was a material misstatement or omission, liability attaches
unless the seller can show that reasonable due diligence would not
have uncovered the error. Of course, that does not mean that any
misstatement will result in liability. The misstatement must be
“material,” which, under the securities laws, means
that there is “a substantial likelihood that the disclosure
of the omitted fact would have been viewed by the reasonable
investor as having significantly altered the ‘total
mix’ of information made available.”84

The Final Rules

How this exemption will work in practice is yet to be seen. The
exemption requires implementing regulations from the SEC and FINRA,
and the SEC only just issued final rules in October 2015, which
will become effective on May 16, 2016—several years after the
JOBS Act directed the SEC to issue regulations.85

Neither the delay nor the exemption’s complexity is
surprising. The concept of investment crowdfunding was met with
considerable apprehension, by lawmakers and by some within the
industry and academia, when first proposed.86 Securities regulation exists, in part, to
protect investors. If portions of the rules are rolled back, one of
two things must happen: either investors lose needed protection and
are thereafter defrauded or otherwise unjustly parted from their
wealth, or those portions of the rules were unnecessary and
therefore many assumptions underlying the architecture of the
securities laws are incorrect.

One of those assumptions is that any offering sold to the public
must provide certain required disclosures. Under this assumption,
the SEC must prescribe the disclosures because retail investors are
not sophisticated enough to know what information they should
request before investing. There is some validity to this
assumption. Many retail investors may not know enough about
corporate finance or governance to know what information exists,
never mind which pieces of information they should consider before
investing. The benefit of having the information provided through
SEC-mandated disclosures is that every company’s filing will
look similar, making it easy for the investor to compare
disclosures across companies.

While it may be beneficial for some investors to have assistance
in obtaining information about potential investments, it is not
clear that all of the disclosures required for a public company
would be valuable for a potential crowdfunding investor. Despite
the talismanic properties sometimes attributed to this body of
disclosures, it is unlikely that a crowdfunding investor looking to
invest $100 or $1,000 would benefit from such a large volume of
information.

Additionally, SEC-mandated disclosures are not the only way for
an investor to obtain information. The nature and structure of
crowdfunding encourages information-sharing and engagement. Some in
the industry argue that there will be no fraud in crowdfunding
because the “crowd”—that is, the online investing
community—will quickly identify and report
fraudsters.87 Such a blanket
dismissal of the risk of fraud is naïve, as there is nearly
always fraud where there is money to be made, but the ability of
investors and potential investors to share information seamlessly
online will likely check some illicit activity. The proposed rules
include a specific provision allowing for communication through the
funding portal, including communication between the issuer and
investors.88 Moreover, the
issuer’s ability not only to provide information to
investors, but to interact and engage with them, offers a new means
of responding to specific requests. An issuer need not anticipate
all investors’ requests and satisfy them with one data dump.
The disclosures can be an ongoing, interactive process.

As for the need for guidance in understanding what information
is relevant to making an informed investment decision, the SEC is
not the only source for such assistance. Private sector actors can
provide help, too. For example, CrowdCheck (of which the author is
a founder and owner) is a company founded specifically to help
investors conduct the due diligence necessary to making an informed
decision when investing in a crowdfunding offering.

The second assumption behind the securities laws’ approach
to protecting retail investors is that they must be prevented from
investing in companies and participating in transactions deemed to
be risky. The near ban on retail investment in private placements
is the best example of this type of investor protection. The IPO
process itself functions as another such restriction. The process
of conducting an IPO is almost entirely focused on preparing,
filing, and disseminating disclosures. The disclosure process
therefore also serves a gatekeeping function in that only certain
companies—generally those that are above a certain size and
relatively well established—will find an IPO worthwhile. Seen
through this lens, the burden of preparing for an IPO is a plus. It
weeds out the smaller, younger, riskier companies and thereby
prevents retail investors from investing in them.

Given these assumptions, it is not surprising that, before the
JOBS Act, there were no meaningful opportunities for retail
investors to invest in a company at the very start of its
lifecycle. The fact that retail investors have not typically been a
part of this market has made the task of designing appropriate
regulations for crowdfunding offerings difficult. The exemption
does not work if the issuer must make the same disclosures it would
make for an IPO. Those disclosures are simply too burdensome for
offerings and companies of this size. The exemption would be
unusable.

Although the SEC has sought to balance these concerns and
develop a workable exemption, it does not seem to have been
successful. The final rules have significant defects, all of which
derive from using a template created for large public companies to
develop a regulatory regime for what are extremely small offerings.
For example, the rules require issuers to follow U.S. Generally
Accepted Accounting Principles (GAAP). Among other requirements,
this requires the use of accrual-based accounting. In accrual-based
accounting, debits and credits are recorded as they accrue. If, for
example, a company orders inventory in June with payment due in
August, the debit is recorded in June. Most small businesses,
however, use cash-based accounting, in which credits and debits are
recorded as the money flows into or out of the company’s
accounts. Under cash-based accounting, the inventory ordered in
June but paid for in August would be recorded in August.

In some ways, accrual-based accounting provides a more accurate
picture of the company’s financial situation. If a company
has $50,000 in cash on hand but must pay $45,000 in the next few
weeks, it is more accurate to say that the company has $5,000
rather than $50,000. In a large company that always has a number of
substantial orders and payments outstanding, accrual-based
accounting is essential to understanding the company’s
health. In a very small company, however, there are likely to be
only a small number of credits or debits outstanding and disclosing
individually any that are of significant size is easily done.
Accrual-based accounting is unnecessary.

Under the rules, issuers must also make annual disclosures to
the SEC and on the company’s own website until the company
goes out of business or acquires all of the outstanding
crowdfunding securities it issued. An issuer must therefore
calculate the cost, not only of preparing for the offering itself,
but also of annual disclosures on an ongoing basis.

The SEC, in accordance with administrative law, first published
proposed rules on which the public was invited to comment, and
subsequently issued the final rules. While it is the agency’s
prerogative to make changes to final rules as it sees fit, some of
the changes between the proposed and final rules for Title III were
surprising. For example, the final rules have introduced a risk
that a crowdfunding issuer may be forced to register as a public
company. Most companies go public by choice, but a provision of the
securities laws mandates that a company register with the SEC if it
has more than 2,000 shareholders or 500 non-accredited
shareholders, and $10 million in assets.89 It is essential to the crowdfunding model
that an issuer be able to raise money from a crowd of investors.
Requiring issuers to register as public companies if they have more
than 500 non-accredited investors, including crowdfunding
investors, would make the crowdfunding exemption unworkable and
would fundamentally undermine its premise.

The proposed rules therefore included a provision that would not
count crowdfunding investors toward the 500-shareholder total.
Unfortunately, the final rule introduces a risk. The issuer can
exclude the crowdfunding investors, but only if it complies with
certain requirements. If the issuer, for example, misses filing its
ongoing disclosures, it loses the exemption, meaning that it would
have to file as a public company if it has more than 500
non-accredited investors. This could wreak havoc with small
crowdfunding issuers. In the tumult that characterizes the daily
operations of a start-up, where a handful of people fill the roles
that require dozens at a larger enterprise, and where legal and
compliance issues may fall to the overburdened CEO, missing an SEC
filing is a real possibility. Even if one believes that these
ongoing filings are necessary to investor protection, a single
lapse should not invalidate the exemption for all crowdfunded
securities the company has issued.

Not all of the changes to the proposed rules were bad, however.
For example, the proposed rules had prohibited platforms from using
subjective criteria to select the offerings listed on their sites.
The rationale was that such curation was akin to making investment
recommendations—I’ve listed this security on
my site because it’s a good investment and you should
therefore buy it—and that platforms should not engage in such
activities. Commenters, however, rightly noted that this was in
considerable tension with the liability such platforms will
shoulder and the structure of the act, which places them in a
gatekeeping role for the industry. Under the final rules, platforms
may “[d]etermine whether and under what terms to allow an
issuer to offer and sell securities in reliance on Section 4(a)(6)
of the Securities Act (15 U.S.C. 77d(a)(6)) [the JOBS Act provision
that allows crowdfunding] through its platform, provided that the
funding portal otherwise complies with Regulation Crowdfunding
(§§ 227.100 et seq.).”90 Funding portals may not make any assertions
about the quality of the investments on their sites, but they may
use whatever methods they choose to select the offerings they will
list. This change provides not only a means for platforms to reduce
liability exposure, but also a certain level of investor
protection. A platform, by creating a carefully curated list of
offerings, can cultivate a reputation for listing only well-run
companies, making its offerings more attractive to investors and
issuers alike and providing a useful service to
investors.91

Given the complexity of the legislation and of the surrounding
securities regulations, it is ultimately unlikely that most issuers
will be able to successfully complete a crowdfunding offering
without some assistance from legal or financial professionals. With
the amount of money a company can raise in a crowdfunding offering
capped at $1 million, companies may have little room in the budget
to spend on these services. If the cap were raised, which would
require an act of Congress, the exemption might be more attractive,
but given the changes to Regulation A (described below) and
Regulation D, there might simply be no need for Regulation CF (the
crowdfunding exemption).

Additionally, crowdfunding involves receiving investment from
the crowd or from a large and broadly dispersed group of investors.
This means that, for companies that choose to issue equity, any
future investment will have to wrangle with a large and unwieldy
assortment of shareholders. The easiest solution would be to create
a fund that would invest in crowdfunded offerings. Unfortunately,
the JOBS Act explicitly forbids the use of special-purpose vehicles
(SPVs) or other funds under Title III.92 Even if funds were permitted, they would
need an exemption from the Investment Company Act of 1940, which
imposes certain registration and other requirements on funds, to be
viable. This is yet another area where the law simply is not built
for companies the size of crowdfunding issuers. It is almost
impossible that any fund specializing in crowdfunding would be
well-funded enough to justify the expense of registration under the
Investment Company Act.

With better underlying legislation and better implementing
regulation, investment crowdfunding might have provided a useful
contribution to capital formation for the smallest companies.
Properly done, investment crowdfunding would provide small, quick
injections of cash into very early stage or very small companies.
For example, a local coffee shop looking to buy new equipment or a
two-person start-up needing cash to allow its founders to quit
their day jobs and spend a year or two building the business until
it can bring in revenue might be good candidates for an effective
form of crowdfunding. Unfortunately, the current exemption is too
unwieldy to be viable for such uses.

Even so, it is not realistic to believe that, whatever its form,
investment crowdfunding would bring quite the number of new
ventures and jobs that some of its advocates imagined.93 In its current incarnation, it is unlikely
to change very much at all. However, its greatest benefit may not
be its ability to assist in capital formation directly. The
greatest benefit the new exemption provides may be the simple fact
that it is new. Regulation in general, and securities regulation in
particular, has a tendency to discount, and therefore stifle,
innovation. Regulation CF is valuable simply in its willingness to
venture into the unknown. It is too bad it was not better done, but
it opens the door for more innovation in the future.

Policy Recommendations

Both the implementing regulations and the underlying legislation
creating the crowdfunding exemption have significant flaws. A few
changes, some more ambitious than others, could make crowdfunding a
viable option for capital formation:

Creating a de minimis exemption for crowdfunding.
Informal—extralegal—crowdfunding has always existed.
It’s what happens when someone opens a new restaurant and
invites mom, dad, some cousins and a few buddies to “go in
on” the restaurant and become “part owners,”
which is often structured (albeit unwittingly) as a sale of stock
and not as the creation of a partnership. These types of
arrangements, despite the headaches they give attorneys who later
need to unwind the sales, will persist whether they are legally
sanctioned or not. Rather than create unnecessary complexity, it
would be simpler to create an exemption for offerings under, for
example, $500,000. To the extent investor safeguards were deemed
necessary, the exemption could include restrictions either on the
amount any one investor could invest (similar to those that exist
under Regulation CF) or restrictions on how the offering could be
advertised.

Permitting the use of special purpose vehicles (SPVs) under
Regulation CF, removing the restriction on crowdfunding by
investment companies, and providing an exemption under the
Investment Company Act that would make the creation of a
crowdfunding investment fund feasible. This would allow the
development of funds created for the purpose of investing in
crowdfunding offerings, giving investors the opportunity to
diversify and to leverage the expertise of a fund manager.
Ultimately, this change would improve investor protection. One of
the biggest criticisms of investment crowdfunding has been the fact
that the businesses seeking crowdfunding are almost guaranteed to
be small and young, and therefore risky. An investor could, instead
of holding shares of one risky asset, hold a diverse basket of
crowdfunding securities.94
Additionally, the fund manager would have an incentive to provide
more thorough vetting and diligence on the securities to be
included in the fund, leading to potentially better investments for
the investors. Finally, crowdfunding is, more than most types of
investing, about investing in more than simply a business
enterprise. Crowdfunding imparts a certain emotional benefit on
investors who may invest in a company because of personal beliefs
or affiliation. The availability of crowdfunding funds could enable
the creation of, for example, a fund comprised of businesses within
a specific town, or businesses devoted to a certain cause, allowing
investors to invest broadly in places or concepts they
cherish.

Reverting to the proposed rule that would have made all
securities issued under Regulation CF exempt from the 12(g)
requirements regardless of future behavior on the part of the
issuer. The current final rule introduces too much uncertainty and
creates a substantial risk that an issuer will be required to file
as a public company because of an innocuous lapse in compliance. At
the very least, there should be a grace period during which an
issuer can cure the deficiency and retain its private status.

Title IV: Regulation A Revisited—the Backdoor to
Crowdfunding

Although most discussion of securities crowdfunding has,
understandably, focused on the new exemption in Title III, another
exemption can also provide a crowdfunding-like option for issuers.
Regulation A is an old exemption in the securities laws, dating
back to 1936. It has been dubbed the “mini IPO” because
it permits small offerings of freely tradable securities to the
general public without full registration with the SEC. It has
historically been challenging for companies to use because of the
cap on how much can be raised in an offering under this
exemption—pre–JOBS Act, the cap was $5
million—and because of restrictions related to state law,
which will be discussed in this section. In fact, companies have
found it so challenging to use that it has been deemed unworkable
and fallen almost entirely out of use.

In 2011, there was only one qualified Regulation A offering. By
way of comparison, there were 8,194 Regulation D offerings (private
placements) for less than $5 million and even 312 registered public
offerings for less than $5 million in the same year. Exemptions
from full registration, as Regulation A is, are intended to be
easier and more cost-effective than a full public offering. The
fact that there were more than 300 times the number of sub-$5
million IPOs in 2011 than Regulation A offerings suggests that
Regulation A was not working as intended.95 Even one of the most robust years for
Regulation A, 1997, produced only 56 qualified
offerings.96

What was wrong with Regulation A? Two things: the $5 million cap
and lack of federal preemption. At first blush it seems strange
that the $5 million cap would be problematic since there have been
IPOs for less than $5 million. The reason is that the lack of
federal preemption made the legal and other compliance requirements
so costly that they quickly ate into the $5 million issuers were
allowed to raise under the exemption.

An offering under Regulation A is, even post-JOBS Act, more
complicated than raising money under Regulation D. First, the
company must be an eligible issuer. Unlike Regulation D, Regulation
A places restrictions on which companies can use the exemption. It
cannot be used by a reporting company, that is, a company that has
had an IPO, lists its securities on a national exchange, or has
more than 2,000 shareholders of record (or more than 500
non-accredited shareholders of record). The issuer must also be
either a U.S. or Canadian company. Second, the company must
complete a scaled-down version of the more robust registration
process required before an IPO. Third, the company cannot, as in
the case of Regulation D, raise an unlimited amount of money using
this exemption. Finally, the offering must be accompanied by a
disclosure document known as an offering circular. An offering
circular, while more modest in scope than the prospectus that
accompanies an IPO, is nonetheless a significant undertaking
requiring the assistance of legal counsel. For example, the
circular that accompanied one of the very few recent Regulation A
offerings, conducted by Fundrise in 2012, was 40 pages, not
including the audited financial statements and seven appended
exhibits.

Also, unlike Regulation D, Regulation A is an exclusive safe
harbor. In the case of Regulation D, which is not an exclusive safe
harbor, an issuer may fail to meet all of the requirements to
qualify for the Regulation D exemption and yet still be exempt from
registration. Regulation D carves out space in the very vague
statutory exemption for issues not involving a public offering. The
rationale behind Regulation D is that we will say “well, a
lot of things might be a non-public offering, but we will say that
if you meet the requirements of this Regulation, your offering will
definitely be non-public.” Regulation A, however, is
not a carve-out within a broader exemption; it is the
exemption. Any deviation from its requirements means that, if the
offering cannot qualify for another exemption and yet is not fully
registered, it is in violation of the Securities Act. 97

Even after the necessary materials have been filed with the SEC,
the issuer’s work is not done. The SEC staff review the
materials and may return to the issuer with questions and requests
for additional information or changes to the offering materials.
These changes often must be addressed by the issuer’s lawyers
and, in the case of questions about the company’s financial
statements, by its accountants. There may be a number of written
communications back and forth between the SEC staff and the issuer
and its team, plus informal conversations as the details of the
offering materials are ironed out. Due to the cost and effort
required to respond to SEC questions, many issuers who begin the
process of conducting a Regulation A offering never finish it. For
example, in 2011, there were 19 initial Regulation A offerings
filed but only one qualified.98

Lack of Federal Preemption

If issuers had only to comply with federal law, more might have
found it worthwhile to meet these obligations to be able to raise a
few million dollars. However, they have to comply with state
regulations as well. In legal terms, the federal government may,
where it has jurisdiction, elect to preempt state law. In 1996,
Congress provided federal preemption for a wide range of securities
through the National Securities Markets Improvement Act (NSMIA).
Pursuant to this act, securities listed on the New York Stock
Exchange and NASDAQ, as well as securities sold in reliance on the
Regulation D exemptions, are exempt from state registration
requirements.

Securities sold under the Regulation A exemption, however, were
not included in the act and have therefore been subject to state
registration requirements.

Each state has its own agency that regulates the sale of
securities within its borders. These agencies oversee state
securities laws, known as “blue sky” laws. At the
federal level, every offering of securities must be registered with
the SEC, or qualify for an exemption. Similarly, for every offering
of securities in the United States, the issuer must register that
offering with the state securities regulator, unless the offering
either qualifies for an exemption under state law, or federal law
has preempted the state’s regulation of the offering.

While there are similarities among the 51 jurisdictions (the 50
states plus the District of Columbia), each jurisdiction has its
quirks. An issuer subject to these rules must therefore carefully
review the laws of each jurisdiction in which it plans to offer
securities to ensure compliance. Offering documents must also be
submitted to each jurisdiction, and each set of documents must
comply with that jurisdiction’s requirements, which include
not only the content of the required disclosures and filings, but
also the format in which these disclosures must be made.

Moreover, a majority of states include “merit
review” as part of the offering process. This means that the
state securities board reviews the offering to determine whether
the terms are, in the words of many state statutes, “fair,
just, and equitable” to the investor and, in some cases,
ascertains whether the securities are likely to present a return on
investment to the purchaser.99
While the existence of merit review does not necessarily impose
additional compliance costs on the issuer, it does introduce
uncertainty. An issuer may complete all necessary documentation,
comply with all relevant requirements, and incur all applicable
costs associated with preparing an offering for a particular state
only to be rejected by the state securities board as too
risky.100 Even if the state
board accepts the offering, however, the process at the state level
typically mimics that at the federal level, requiring several
rounds of communication between issuer and regulators, and the
input of the issuer’s lawyers and accountants. Each iteration
costs both time and money for the issuer.

Certainly one reason for the paucity of Regulation A offerings
is the availability of Regulation D. As discussed earlier,
Regulation D has no cap and requires no specific disclosures. There
is no back-and-forth with the SEC, and no risk that the offering
will not be accepted (although, of course, any offering carries the
risk of liability if it fails to comply with regulations).
Regulation D offerings also benefit from federal preemption. And,
now that Rule 506 offerings may be advertised via general
solicitation, the public nature of Regulation A offerings may be
even less attractive. Regulation D offerings tend to be cheaper
than Regulation A offerings. While the cost of each can vary
considerably based on the size of the offering, the complexity of
the issuer, and other factors, a pre–JOBS Act Regulation A
offering tended to cost somewhere around $100,000 while a
Regulation D offering can sometimes be done for as little as
$20,000 or $40,000.

Given the benefits of a Regulation D offering, why would a
company choose Regulation A? There are two reasons. First,
securities sold pursuant to a Regulation A offering are freely
tradeable in the secondary market. This liquidity increases their
value and lowers the cost of capital. Second, issuers are not
indifferent to who buys their securities, especially when the
company is very small.

Fundrise, for example, is a real estate development company
that, according to its website, seeks to “democratize local
investment” by facilitating investment in real estate by
local investors. Given the company’s mission, having
unaccredited but local investors for its projects is crucial to its
vision. The company has used Regulation A in the past to enable
unaccredited investors to participate in its offerings. However, it
found the exemption’s compliance requirements unworkable.
According to Fundrise, the filing process took six months to
complete, required the assistance of eight attorneys, and cost more
than $50,000 in legal fees.101
The company also notes that its final filing document weighed 25
pounds. Until recently, it had reverted to relying exclusively on
accredited investors and Regulation D offerings. In late 2015,
however, it announced a new Regulation A offering, under the new
post-JOBS Act rules.102

As for that sole Regulation A offering in 2011, its issuer has
also spoken out about the challenges of complying with the
regulation’s requirements and with numerous state regulatory
regimes. The 2011 Regulation A offering was for $5 million to fund
a Broadway revival of the musical Godspell. In an
interview at the time, the lead producer, Ken Davenport, expressed
his interest in having “a community of investors since the
musical is about a community of people.”103 This community came at a cost, however.
Davenport later recounted the efforts required to comply with
various state regulatory regimes. Texas requested a $250,000 bond,
he reported, while Maryland required that he pass FINRA’s
Series 63 Uniform Securities State Law Examination.104 The legal and other costs of completing
the $5 million raise, he said, totaled $200,000. Although The
Godspell LLC successfully completed its round of funding, other
production companies have not followed suit, preferring to use the
more efficient Regulation D exemption to fund Broadway shows.

JOBS Act Changes to Regulation A

Title IV of the JOBS Act aimed to revitalize this exemption by
raising the cap to $50 million, with a periodic review to determine
if the cap should be raised further, and by classifying the
securities sold under the exemption as “covered” if
offered or sold to “qualified purchasers.” Under the
Securities Act of 1933, a covered security is exempt from state
registration requirements.

Qualified purchaser is a term that has been around for a while
but that has never been definitively defined. As part of the
process of drafting rules to implement this title of the JOBS Act,
the act directed the SEC to define this term and, in the end, the
SEC defined the term quite broadly indeed. First, the SEC created
two tiers of offerings under Regulation A. Tier 1 looks a lot like
old Regulation A, but with a $20 million cap instead of a $5
million cap. Offerings must comply with all Blue Sky (that is,
state) laws, but ongoing reporting requirements are minimal and
financial statements need not be audited unless the company has
already prepared audited statements for other purposes. (As many
state regulators require audited statements, most issuers using
Tier 1 will wind up needing audited financials in the end.) Anyone
can buy securities sold in a Tier 1 offering and can invest as much
money as they wish.

Tier 2 offerings, meanwhile, have a $50 million cap and are
exempt from state registration requirements. However, financial
statements must be audited. Additionally, Tier 2 offerings impose
ongoing reporting obligations, including semi-annual and annual
reports, and reports necessary to ensure information is current.
Non-accredited investors may invest only 10 percent of the greater
of income or net worth in any one offering.

Finally, under Tier 2, securities may only be offered and sold
to “qualified purchasers.” The final rule states that a
qualified purchaser is “any person to whom securities are
offered or sold pursuant to a Tier 2 offering of this Regulation
A.”105 That is to say,
anyone at all. The SEC could not have defined the term any more
broadly than this.

The SEC’s liberality has not gone unchallenged. Several
state regulators, through their representative association, the
North American Securities Administrators Association (NASAA), have
objected to the SEC’s definition of qualified purchaser,
arguing that the SEC’s interpretation is “clearly
contrary to the plain language and intent of the applicable
statutes.”106 State
officials from Montana and Massachusetts have filed suit against
the SEC, seeking to enjoin the agency from permitting offerings to
go forward under the new rules. These suits are currently
pending.

Although the SEC certainly acted boldly in defining qualified
purchaser as it did in Tier 2 offerings, its actions are supported
by a careful consideration of the JOBS Act. The purpose of the JOBS
Act is “to increase American job creation and economic growth
by improving access to the public capital markets for emerging
growth companies.”107
Congress included changes to Regulation A in the act, liberalizing
its terms. The act also included a provision ordering the
Government Accounting Office (GAO) to conduct a study on “the
impact of State law regulating securities offerings, or ‘Blue
Sky law,’ on offerings made under Regulation
A.”108 The GAO study
concluded that state registration requirements were “costly
and time-consuming for small businesses” and that Regulation
D’s federal preemption made that exemption more attractive
for small issuers.109
Congress’s inclusion of the GAO study in the JOBS Act ties
the changes to Regulation A to issuers’ concerns with
state-level compliance. The GAO’s findings confirm that the
lack of federal preemption for Regulation A contributed to small
companies’ strong preference for Regulation D. It is
therefore neither arbitrary nor capricious for the SEC to conclude
that broad federal preemption would promote the goals of the JOBS
Act.

Only a handful of issuers have filed paperwork for Regulation A
offerings since the new rules became effective. Some of these
filings have fundamental flaws that make it unlikely they will
qualify. Some other issuers, however, have filed papers recently or
have expressed interest in the exemption but are taking a more
measured approach before jumping in. A key consideration for
issuers is the speed with which the SEC reviews and qualifies
offerings; many companies are unwilling to wait more than 90 days
to start fundraising, especially given the fact that Regulation D
offerings require no paperwork to be filed with the SEC and no
approvals. However, while there is no limit on the amount of
capital that can be raised under Regulation D, the limitations
Regulation D imposes on investors can make raising larger amounts
more difficult. If the SEC can review and qualify the offerings
quickly enough, the new Regulation A may be a useful source of
capital for companies that need a large injection of funds but that
are not quite ready to enter the public markets. This category
includes a large swath of small business models. While a successful
Regulation A offering does need the assistance of lawyers, the
amount that can be raised under the exemption is sufficient to make
such an expense worthwhile. It may be that the changes to
Regulation A are the most important of all the JOBS Act’s
provisions.

Policy Recommendations

On the whole, the changes to Regulation A are very welcome and
promising. But if the SEC were to make two changes, the new
Regulation A would be even more effective:

extending federal preemption to all Regulation A offerings;
and

providing explicit federal preemption of state Blue Sky laws
for registered broker-dealers trading in securities originally
issued under Regulation A. Currently, while securities sold
pursuant to Regulation A are freely tradable, restrictions remain
at the state level on how a registered broker-dealer can handle
these securities. Removing those restrictions on secondary trading
would make the securities more liquid.

Given the fact that Regulation A’s unpopularity was due
overwhelmingly to the need to comply with state as well as federal
regulators, it seems unlikely that the new Tier 1 offering under
the revised Regulation A will be very popular. It is difficult to
see how state-level review adds appreciable investor protection,
and there is therefore no need for the Tier 1/Tier 2 distinction.
The disclosure requirements currently applicable to Tier 1 should
apply to all Regulation A offerings, including those above $20
million, and all Regulation A offerings should be exempt from state
registration requirements.110

Additionally, making the initial offering exempt from state
registration is, at best, a half measure if the securities cannot
be easily traded in the secondary market.

Titles V And VI: Staying Private Longer

As discussed earlier, companies typically decide to go public
because they need access to the kind of capital that is only
available in the public markets. This is a big decision in the life
of a company and not one that is taken lightly. In addition to the
considerable cost of the IPO and ongoing compliance costs, a public
company simply must be run differently than one that is privately
held. The company loses control over who holds its stock, and its
board and executives now have outsiders looking over their
shoulders. Its inner workings, previously open only to shareholders
and creditors, are now laid bare for inspection by any member of
the public who can access the SEC’s online filing system,
including competitors. Many companies, although highly successful,
choose nonetheless to stay private.

There are, however, circumstances that require a
company to go public. The two triggers are total assets and
shareholders of record; if both exceed an established limit, the
company will be considered a public company and must register or be
found in violation of the securities laws.111 Before the passage of the JOBS Act, these
thresholds were assets exceeding $10 million and more than 500
shareholders of record. The JOBS Act raises the threshold for
shareholders of record to 2,000, as long as these shareholders are
accredited; the threshold for non-accredited shareholders remains
at 500.

It should be noted that the threshold considers only
shareholders of record in making the calculation. The
distinction between shareholders and shareholders of record is an
important one. Most individual investors’ securities are held
in brokerage accounts. The brokerage is the shareholder of record
for these securities, not the brokerage clients, who are the
beneficial owners of the securities. Therefore a brokerage may hold
shares in a company for 100 account holders (the beneficial owners)
but only the brokerage will count as the shareholder of record. In
the industry a brokerage holding securities in this way is said to
hold securities “in street name” for its clients. So
the threshold is actually much higher than it initially
appears.

Titles V and VI of the JOBS Act raise the thresholds for,
respectively, issuers generally and for bank holding companies
specifically to $10 million in assets and 2,000 total shareholders
of record or 500 non-accredited shareholders of record. The effect
of this change is to permit companies to remain privately held
further into their lifecycles or to remain private
indefinitely.

This seems to present a paradox: the JOBS Act both promotes
early stage IPOs by creating an IPO on-ramp and encourages
companies to stay private longer by raising the assets and
shareholder thresholds. These goals are not contradictory, however,
as they give more flexibility for smaller companies both in how
they raise capital and how they govern themselves. Additionally,
companies that wait longer to go public and can more carefully
choose when an IPO makes sense for their business may present a
higher quality IPO at the point they do enter the public markets.
And there will always be companies that need to go public.
Companies that receive private equity funding, for example, are
under a great deal of pressure to provide an exit for their
investors. Sometimes this exit can be through acquisition by
another company, but often it’s through an IPO. Other
companies, because of the culture of their industry, may need to go
public to demonstrate they have achieved a certain level of success
and maturity. These are appropriate reasons for a company to enter
the public markets because they depend on the company’s own
internal decisionmaking. Titles V and VI assist in letting
companies make these decisions themselves, in line with their own
business models and projections.

Policy Recommendations

The decision to register an offering and to access the public
capital markets should be one a company makes because it is in the
best interest of the company. It should not be either a step a
company is forced to take, or a barrier to growth for companies
that do not wish to operate as a public company. Congress should
repeal Section 12(g) of the Securities Exchange Act of 1934.

Conclusion

The JOBS Act provides some of the innovation and flexibility
required to provide adequate capital access for the wide range of
small business models that exist in our economy. The JOBS Act
achieves this, in large part, by departing from the traditional
approach to securities regulation at the federal level. The SEC has
a three-part mandate: (1) to facilitate capital formation; (2) to
protect investors; and (3) to maintain fair, orderly, and efficient
markets.112 In finding a balance
between facilitating capital formation and protecting investors,
the SEC has typically taken the position that less-sophisticated,
less-wealthy investors are best protected through exclusion from
investment in the riskiest companies. And early stage companies are
risky. According to data from the Bureau of Labor Statistics, 20 to
25 percent of new businesses failed in the first year during the
period 1994 to 2010, and roughly 50 percent fail by the fifth
year.113

Preventing people from investing in risky companies may protect
them from loss, but it also may protect them from gain. Investment
is risk. People invest to increase their wealth. The
reason investment increases wealth is twofold. First, there is the
time value of money. Investors buying bonds, for example, allow the
issuer to use their money now and forgo using it themselves because
the issuer will return the money with interest in the future.
Second, there is risk. Investors buying bonds not only forgo the
use of the money for a period of time, they also risk losing it if
the issuer is unable to repay the money. To make the risk
worthwhile, the issuer offers interest. If there is no risk, there
is no reward. “Riskiness” does indeed mean that there
is a high likelihood of failure, but it also means that, if the
business succeeds, the return is likely to be high.

Before the JOBS Act, the ability of the least-sophisticated,
least-wealthy investors—retail investors—to invest in
very early stage companies was almost nonexistent. Meanwhile, the
investment available to early stage companies was similarly
limited. Some have argued that these limitations are beneficial.
There is concern that adverse selection will leave only the
companies that have been rejected elsewhere to seek investment
through online offerings, whether through 506(c) of Regulation D,
Regulation A, or Regulation CF. Or that the ability to solicit
investment online will attract outright fraudsters to prey on
investors. Will there be fraudsters? Almost assuredly. As mentioned
above, where there’s money, there’s fraud. But thieves
never needed legitimate exemptions for an opportunity to dupe
would-be investors; they can ply their cons online with or without
Regulations A, D, or CF. As for adverse selection, this assumption
at best betrays a certain stuffiness—is there anything
worthwhile on that Internet thing?—or at worst, elitism. The
availability of online investing provides improved access for both
investors and issuers who reside outside the financial strongholds
of the northeastern and Pacific cities. Some issuers may go online
as a last resort, but many may choose to offer securities online
because of its convenience, ability to reach a broader audience,
and because the issuer or its potential investors are young enough
that they expect to do everything online (and preferably from their
smartphones).

The JOBS Act has made some changes that may open up such
investment to new investors. The JOBS Act, however, is far from
perfect:

While Title I streamlines the IPO process, the question remains
whether many of the deferred disclosures are necessary at all.

Title II makes it easier for issuers to find investors for
private placements, but offerings are still largely restricted to
accredited investors and there is little to support the notion that
a certain level of income or assets renders a person either
financially sophisticated or especially knowledgeable about any
given industry.

Title III crowdfunding will be hamstrung by the very low $1
million cap on the amount that an issuer can raise, and most
issuers will likely find the ongoing reporting requirements and
other disclosures to be unduly onerous, especially given the other
options presented by Regulations A and D.

Title IV provides a much-needed update to Regulation A and Tier
2 will likely prove to be valuable. However, a better solution
would have been to provide full federal preemption for all
offerings under the exemption. It is unclear what benefit state
review of these offerings provides and, for any offering, merit
review is anathema to a properly functioning market, as
demonstrated by Massachusetts’s regulators’ inability
to recognize the value in the Apple IPO.

Titles V and VI will assist companies by making the decision to
go public one that the company can make based on its own business
needs, although it is unclear that requiring a company to go public
at any point provides benefits either to the company, its
shareholders, or the market as a whole.

Clearly, the JOBS Act is not all that is needed to provide
robust growth in the small-business sector. As new technology
emerges and innovation in connecting investors with issuers
follows, additional changes will be needed. The JOBS Act, however,
provides a useful template for how regulators can work to
accommodate regulation to the needs of the market instead of the
other way around. Instead of approaching new technology as a jungle
that needs to be tamed by government intervention, a better
approach, attempted but not fully realized in the JOBS Act, would
be for regulators to look for ways to remove obstacles to economic
growth. This is especially true in the small-business sector, where
firm diversity and quick proliferation of new ideas requires
equally nimble financial solutions.

A. Appendix: Summary of Policy
Recommendations

Title I

The SEC should:

Establish a process for determining whether disclosures
required as part of the IPO process are valuable to the market and
whether their value merits the burden of compliance.

Use this process to conduct a review of the current IPO
process, with the goal of repealing requirements that are unduly
burdensome.

Conduct regular reviews of existing and new requirements using
these criteria, repealing requirements that are unduly
burdensome.

Title II

Eliminate the accredited/non-accredited investor distinction or,
if that is not possible, Congress should:

Broaden the current definition of accredited investor to
include individuals who can demonstrate through a brief and simple
test an understanding of basic finance and investment
concepts.

Create a new category that would include individuals who can
demonstrate, through work experience, a professional qualification,
or a university-level degree in a relevant field, knowledge of a
specific industry. These individuals would be eligible to invest in
companies within each individual’s area of expertise.

Permit the primary residence to be included in the calculation
of accredited investors’ assets.

Title III

Congress should:

Create a de minimis exemption for offerings under $500,000 that
would require no filings with, or disclosures to, the SEC.
Restrictions on how much an investor can invest and/or on
advertising of the offering could be included if necessary.

Lift the restriction on crowdfunding investment companies and
create an exemption under the Investment Company Act to permit such
funds to operate with limited registration and disclosure
requirements.

The SEC should:

Remove the conditionality from the 12(g) exemption to ensure
that any securities properly issued under Regulation CF remain
exempt, regardless of the issuer’s compliance with ongoing
disclosure requirements (or anything else).

Title IV

The SEC should:

Extend federal preemption to all offerings under Regulation
A.

Provide explicit federal preemption of state Blue Sky laws for
transactions in the secondary market by registered broker-dealers
for securities properly issued under Regulation A.

3. For a review of the role of individual
entrepreneurship in American social thought on prosperity, see Jim
Cullen, The American Dream: A Short History of an Idea that
Shaped a Nation (Oxford: Oxford University Press, 2002).

11. “IRS Faces Several Challenges as It
Attempts to Better Serve Small Businesses,” Government
Accountability Office, Tax Administration, August 2000, p. 3,
www.gao.gov/archive/2000/gg00166.pdf.

12. This is the definition provided by the main
trade association representing small businesses, the Small Business
and Entrepreneurship Council. “Small Business Facts and
Data,” Small Business and Entrepreneurship Council, 2015,
http://www.sbecouncil.org/about-us/facts-and-data/.

13. Although some companies, particularly
start-ups, may use credit cards to supplement capital, most small
business owners use them as a cash management tool. Congressional
Oversight Panel, Emergency Stabilization Act of 2008, “May
Oversight Report: the Small Business Credit Crunch and the Impact
of the TARP,” at p. 12 (2010) (Conf. Rep.).

18. The Small Business Administration, a federal
agency, offers some programs to assist small businesses in securing
loans. In general the programs operate through traditional lenders,
providing a guarantee for qualifying small businesses. This allows
the bank to issue a loan to a borrower with a higher risk profile
without increasing the bank’s exposure.

19. National Federation of Independent Businesses,
“The Small Business Lending Crisis,” Trends
Magazine, September 2014, p.7.

20. The average SBA small business loan is
approximately $371,000. Natale Goriel, “6 Step
Guide—How to Get a Business Loan,” U.S. Small
Business Association (blog), September 4, 2013,
https://www.sba.gov/blogs/6-step-guide-how-get-business-loan.

21. Marshall Lux and Robert Greene, “The
State and Fate of Community Banking,” p. 11.

33. Jumpstart Our Business Startups Act (JOBS) Act
§§77-78 (2012). A company may lose its EGC status sooner
if it has $1 billion in annual gross revenues, it issues more than
$1 billion in non-convertible debt in the previous three years, or
is deemed to be a large accelerated filer as defined in 17 C.F.R.
§ 240.12b.

34. To the extent that EGCs find the cost of
underpricing to outweigh the benefits of other features of the IPO
on-ramp they may either opt not to file as EGCs and therefore use
the IPO process as it existed pre–JOBS Act and that still
must be used by non-EGCs, or opt to file as EGCs but provide
selective additional information such as the market suggests is
valuable (which is what seems to be happening in the case of
increased financial statement disclosure beyond the required two
years).

38. The rationale behind exempting people with a
certain level of wealth from the protections offered by a
registered offering is two-fold: (1) people with a large amount of
money can more easily absorb a loss; and (2) money buys advice and
therefore wealthy people are more likely to have access to paid
advisers who can substitute for mandated disclosure.

39. SEC v. Ralston Purina Co., 346 U.S.
119 (1953). The Securities Act states that its registration
requirements do not apply to transactions “not involving any
public offering.” In Ralston-Purina, the U.S.
Supreme Court found that a transaction not involving a public
offering was one in which the investors were able to fend for
themselves. In the particular facts before the case, the Court
found that rank-and-file employees of Ralston-Purina had no special
ability as employees to obtain information about the company and
therefore their purchase of company securities was a transaction
involving a public offering.

40. 17 C.F.R. § 230.501(a). It is important to
note the effect these thresholds have on geographic diversity of
investors. Given the higher costs of living in cities such as New
York and San Francisco, for example, and the attendant higher
salaries at all levels, there will be more people in these
locations who earn $200,000 annually than in lower cost of living
areas. A company located in Nashville or Omaha may have a smaller
pool of potential investors, even controlling for differences in
population size, just because salaries tend to be lower in these
areas.

41. 17 CFR § 230.506(b)(2)(ii).

42. 17 CFR § 230.502(b)(2).

43. In practice, these presumptions are flawed. A
person can be very wealthy and yet have little understanding of
finance or business. Another person may have a deep understanding
of finance or of the issuer’s relevant industry and yet lack
$1 million in assets.

44. Only 10 percent of reported Regulation D
offerings in the period from 2009 to 2012 included non-accredited
investors. Even if the accredited investors ultimately ask for the
same disclosures the rule would require for non-accredited
investors, the disclosures may be cheaper. This is because any
legally mandated disclosure requires an extra level of review,
typically by attorneys, to ensure strict compliance with the
regulations. A voluntary disclosure, on the other hand, must be
accurate but need not conform to any specific regulatory regime.
Ivanov and Bauguess, “Capital Raising in the U.S.: An
Analysis of Unregistered Offerings Using the Regulation D
Exemption, 2009–2012.”

45. 17 C.F.R. § 230.502(c).

46. Ibid.

47. Ivanov and Bauguess, “Capital Raising in
the U.S.: An Analysis of Unregistered Offerings Using the
Regulation D Exemption, 2009–2012. It should be noted that
the SEC uses data from Form D, which must be filed in conjunction
with a Regulation D offering. Many issuers, and their counsel,
follow the strictures of Regulation D to ensure that the offering
is likely to be deemed non-public but do not file Form D, often out
of a desire to keep the offering truly private (i.e., away from the
SEC’s scrutiny). Therefore there are likely additional
offerings not included in these calculations.

49. An example of a business model unlikely to
attract venture capital is a professional services company. The
profit margin on one hour of billable time will always be the same,
whether the company bills 10 hours or 10 million hours. In
comparison, an app developer may invest several million in creating
a product, but after the development costs have been recouped, the
profit margin will increase substantially as more units are
sold.

55. “More than 49 percent of the U.S.-based
companies financed by venture capital firms are located in San
Francisco, Boston, and New York, which suggests that venture
capital plays a primary role in fostering entrepreneurial
communities in their home regions.” Josh Lerner,
“Geography, Venture Capital, and Public Policy,” policy
brief, Harvard Kennedy School of Government policy brief,
March 2010, p. 1, http://www.hks.harvard.edu/index.php/content/download/68616/1247274/version/1/file/final_lerner_vc.pdf.

66. According to a report by the Milken Institute
and the National Center for the Middle Market, only 4 percent of
small and mid-sized businesses are aware of the availability of
general solicitation for private offerings. The Milken Institute
and the National Center for the Middle Market, “Access to
Capital: How Small and Mid-Sized Businesses Are Funding Their
Future,” May 11, 2015, p. 7, http://www.milkeninstitute.org/publications/view/706.

67. Vladimir Ivanov, “Capital Raising Through
Regulation D,” presentation, Securities and Exchange
Commission, Government-Business Small Business Forum, Washington,
D.C., November 19, 2015, Kevin Laws, “Online Fundraising and
Syndicates,” presentation, Securities and Exchange
Commission, Washington, D.C., November 19, 2015. It should be noted
that neither presentation captures all Rule 506 offerings. Ivanov,
who is a senior financial economist at the SEC, drew his data from
Form D filings. Form D is not required for Regulation D offerings
and therefore a survey of Forms D will not present a complete
picture. Laws presented data only from offerings listed on his
company’s platform.

72. The Kickstarter campaigns that have received
the highest levels of funding include a smart watch, a cooler, a
card game, a video game console, and an effort to revive the
children’s television program Reading Rainbow. Nina Zipkin,
“The 10 Most Funded Kickstarter Campaigns Ever,”
Entrepreneur.com, March 30, 2015, http://www.entrepreneur.com/article/235313. The
most popular GoFundMe campaigns have focused on assisting families
with medical bills or providing support to children who have lost
parents, but other campaigns have included projects such as making
a Baltimore woman’s “relentlessly gay” yard
“more gay.” “The Most Successful GoFundMe
Fundraising Campaigns,” GoFundMe, http://www.gofundme.com/most ; Elisa Lala,
“Woman Launches GoFundMe to Make ‘Relentlessly Gay
Yard’ More Gay,” PhillyVoice (blog), June 22,
2015, http://www.phillyvoice.com/woman-make-her-relentlessly-gay-yard-more-gay-/.

74. Ensuring that a company is not offering a
“security” can be more challenging than simply ensuring
that it is not selling stock or bonds. According to the U.S.
Supreme Court, a security is an investment of money in a common
enterprise due to an expectation of profits depending solely on the
efforts of others. SEC v. W.J. Howey Co., 328 U.S. 293
(1946).

75. This has been called “equity
crowdfunding” by many in the industry, but that term is
misleading. Under the crowdfunding provision of the JOBS Act,
companies will be able to issue both equity and debt. It is likely
that debt, and not equity, will be the more popular form of
investment for companies issuing securities under this exemption.
Given the companies’ risk profiles, the founders’
preference for maintaining control of the company, the illiquidity
of this type of stock, and the “messy cap table”
problem discussed on page 22, debt or, potentially, convertible
debt is likely to be more attractive to investors and issuers
alike.

77. See, for example the “Change Crowdfunding
Law Blog,” which was housed at crowdfundinglaw.com. This blog
was managed by Paul Spinrad, an editor at Wired magazine,
and was updated frequently from 2010 to 2015.

78. Securities Exchange Act of 1934 §
3(a)(4)(A).

79. Securities Exchange Act of 1934 §
3(a)(5)(A). This definition does not include “a person that
buys or sells securities for such person’s own account
… but not as a part of a regular business.” Securities
Exchange Act of 1934 § 3(a)(5)(B).

91. Ironically, investor protection was likely at
the heart of the proposed rule against curation. But it seems the
funding portals as intermediaries are, in fact, in the best
position to provide guidance to investors through the selection of
offerings.

92. Securities Act of 1933 § 4A(f)(3).

93. For example, in his congressional testimony,
Sherwood Neiss speculated that a crowdfunding exemption could lead
to the development of 500,000 companies and 1.5 million new jobs
over a five-year period. Sherwood Neiss, “Crowdfund
Investing—A Solution to the Capital Crisis Facing our
Nation’s Entrepreneurs,” Testimony Before the Financial
Services Committee, Subcommittee on TARP, Financial Services, and
Bailouts of Public and Private Programs, United States House of
Representatives, September 15, 2011, p. 10. https://oversight.house.gov/wp-content/uploads/2012/01/9-15-2011_Neiss_TARP_Testimony.pdf.

97. To understand the difference, consider a
landlord and tenant. The landlord tells the tenant “You may
have any pet that is not too destructive. Any animal that lives
primarily in a cage is presumptively not destructive.” This
is like Regulation D. A turtle or hamster will qualify because
those pets live primarily in cages. But a well-behaved dog would
also qualify. In getting the dog, however, the tenant takes a risk
that the landlord will determine that the dog is, in fact,
destructive. Getting a hamster carries no such risk.Consider now
that the landlord says instead “As a general rule, you may
not have pets. I may, however, identify specific types of pets that
will be acceptable for you to have.” The landlord then
decides that the tenant may have any pet that is fur-covered, has
large front teeth, and is tailless. This is like Regulation A. The
tenant may have a hamster under this regime, but not a rat, despite
the fact that a rat and a hamster are very similar. The rat,
however, has a tail and therefore is not permitted no matter how
well-behaved it may be.

98. There are many reasons an issuer may abandon a
Regulation A submission. The issuer may elect to use Regulation D
instead. Its management may be too disorganized to follow through
with the process; the issuer may simply fold; or the
“issuer” may have been a sham to begin with.

100. In addition to the costs merit review imposes
on the issuer, there is also a cost to investors. As an example,
the Massachusetts state securities board notoriously prevented
Massachusetts residents from participating in Apple
Computer’s IPO in 1980, deeming the company to be “too
risky” for investors. For a brief description see Paul
Atkins, “Great Moments in Financial Regulation,”
Wall Street Journal, April 28, 2010, http://www.wsj.com/articles/SB10001424052748704471204575210624014568114.

110. States would still, of course, still be able
to bring enforcement actions for fraud and other relevant
violations.

111. Companies engaged exclusively in intrastate
commerce and whose securities are sold exclusively intrastate are
not subject to this provision. They would, of course, be subject to
applicable state securities laws and regulations.

112. This mission statement is available on the
SEC website. Securities and Exchange Commission, “The
Investor’s Advocate: How the SEC Protects Investors,
Maintains Market Integrity, and Facilitates Capital
Formation,” http://www.sec.gov/about/whatwedo.shtml.

113. United States Department of Labor, Bureau of
Labor Statistics, “Entrepreneurship and the U.S. Economy:
Chart 3, Survival Rates of Establishments, by Year Started and
Number of Years Since Starting, 1994–2010,” May 7,
2014, http://www.bls.gov/bdm/entrepreneurship/bdm_chart3.htm.

Thaya Brook
Knight is associate director of financial regulation studies at
the Cato Institute. She is an attorney with extensive experience in
securities regulation, small business capital access, and capital
markets.